UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2009
Commission File Number: 1-9700
THE CHARLES SCHWAB CORPORATION
(Exact name of Registrant as specified in its charter)
Delaware | 94-3025021 | |
(State or other jurisdiction | (I.R.S. Employer Identification No.) | |
of incorporation or organization) |
211 Main Street, San Francisco, CA 94105
(Address of principal executive offices and zip code)
Registrants telephone number, including area code: (415) 636-7000
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.
Large accelerated filer | x | Accelerated filer | ¨ | |||
Non-accelerated filer | ¨ (Do not check if a smaller reporting company) | Smaller reporting company | ¨ |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
1,162,131,202 shares of $.01 par value Common Stock
Outstanding on October 23, 2009
THE CHARLES SCHWAB CORPORATION
Quarterly Report on Form 10-Q
For the Quarter Ended September 30, 2009
Page | ||||
Part I - Financial Information | ||||
Item 1. | Condensed Consolidated Financial Statements (Unaudited): | |||
Statements of Income | 1 | |||
Balance Sheets | 2 | |||
Statements of Cash Flows | 3 | |||
Notes | 4 20 | |||
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations | 21 42 | ||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 43 44 | ||
Item 4. | Controls and Procedures | 44 | ||
Part II - Other Information | ||||
Item 1. | Legal Proceedings | 44 | ||
Item 1A. | Risk Factors | 45 | ||
Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | 45 | ||
Item 3. | Defaults Upon Senior Securities | 45 | ||
Item 4. | Submission of Matters to a Vote of Security Holders | 45 | ||
Item 5. | Other Information | 46 | ||
Item 6. | Exhibits | 46 | ||
Signature | 47 |
Part I FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statements of Income
(In millions, except per share amounts)
(Unaudited)
Three Months Ended September 30, |
Nine Months Ended September 30, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Net Revenues |
||||||||||||||||
Asset management and administration fees |
$ | 451 | $ | 596 | $ | 1,439 | $ | 1,827 | ||||||||
Interest revenue |
356 | 497 | 1,063 | 1,485 | ||||||||||||
Interest expense |
(62 | ) | (50 | ) | (161 | ) | (192 | ) | ||||||||
Net interest revenue |
294 | 447 | 902 | 1,293 | ||||||||||||
Trading revenue |
241 | 252 | 772 | 728 | ||||||||||||
Other |
36 | | 132 | 62 | ||||||||||||
Total other-than-temporary impairment losses |
(52 | ) | (44 | ) | (239 | ) | (44 | ) | ||||||||
Noncredit portion of loss recognized in other comprehensive income |
41 | | 201 | | ||||||||||||
Net impairment losses on securities |
(11 | ) | (44 | ) | (38 | ) | (44 | ) | ||||||||
Total net revenues |
1,011 | 1,251 | 3,207 | 3,866 | ||||||||||||
Expenses Excluding Interest |
||||||||||||||||
Compensation and benefits |
371 | 390 | 1,173 | 1,265 | ||||||||||||
Professional services |
70 | 86 | 194 | 254 | ||||||||||||
Occupancy and equipment |
67 | 75 | 245 | 221 | ||||||||||||
Advertising and market development |
34 | 47 | 141 | 181 | ||||||||||||
Communications |
48 | 51 | 155 | 155 | ||||||||||||
Depreciation and amortization |
38 | 38 | 121 | 113 | ||||||||||||
Other |
63 | 65 | 168 | 156 | ||||||||||||
Total expenses excluding interest |
691 | 752 | 2,197 | 2,345 | ||||||||||||
Income from continuing operations before taxes on income |
320 | 499 | 1,010 | 1,521 | ||||||||||||
Taxes on income |
(120 | ) | (195 | ) | (387 | ) | (599 | ) | ||||||||
Income from continuing operations |
200 | 304 | 623 | 922 | ||||||||||||
Loss from discontinued operations, net of tax |
| | | (18 | ) | |||||||||||
Net Income |
$ | 200 | $ | 304 | $ | 623 | $ | 904 | ||||||||
Weighted-Average Common Shares Outstanding Diluted |
1,163 | 1,158 | 1,160 | 1,157 | ||||||||||||
Earnings Per Share Basic |
||||||||||||||||
Income from continuing operations |
$ | .17 | $ | .26 | $ | .54 | $ | .80 | ||||||||
Loss from discontinued operations, net of tax |
$ | | $ | | $ | | $ | (.01 | ) | |||||||
Net income |
$ | .17 | $ | .26 | $ | .54 | $ | .79 | ||||||||
Earnings Per Share Diluted |
||||||||||||||||
Income from continuing operations |
$ | .17 | $ | .26 | $ | .54 | $ | .80 | ||||||||
Loss from discontinued operations, net of tax |
$ | | $ | | $ | | $ | (.02 | ) | |||||||
Net income |
$ | .17 | $ | .26 | $ | .54 | $ | .78 | ||||||||
Dividends Declared Per Common Share |
$ | .06 | $ | .06 | $ | .18 | $ | .16 | ||||||||
See Notes to Condensed Consolidated Financial Statements.
- 1 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Balance Sheets
(In millions, except share and per share amounts)
(Unaudited)
September 30, 2009 |
December 31, 2008 |
|||||||
Assets |
||||||||
Cash and cash equivalents |
$ | 8,116 | $ | 5,442 | ||||
Cash and investments segregated and on deposit for regulatory purposes (including resale agreements of $8,112 at September 30, 2009 and $6,701 at December 31, 2008) |
17,439 | 14,685 | ||||||
Receivables from brokers, dealers, and clearing organizations |
572 | 759 | ||||||
Receivables from brokerage clients net |
7,877 | 7,129 | ||||||
Other securities owned at fair value |
665 | 626 | ||||||
Securities available for sale |
21,300 | 14,446 | ||||||
Securities held to maturity (fair value $3,049 at September 30, 2009 and $244 at December 31, 2008) |
2,979 | 243 | ||||||
Loans to banking clients net |
6,913 | 6,044 | ||||||
Loans held for sale |
66 | 41 | ||||||
Equipment, office facilities, and property net |
646 | 661 | ||||||
Goodwill |
528 | 528 | ||||||
Other assets |
883 | 1,071 | ||||||
Total assets |
$ | 67,984 | $ | 51,675 | ||||
Liabilities and Stockholders Equity |
||||||||
Deposits from banking clients |
$ | 35,500 | $ | 23,841 | ||||
Payables to brokers, dealers, and clearing organizations |
1,245 | 1,100 | ||||||
Payables to brokerage clients |
23,443 | 20,256 | ||||||
Accrued expenses and other liabilities |
1,377 | 1,534 | ||||||
Long-term debt |
1,516 | 883 | ||||||
Total liabilities |
63,081 | 47,614 | ||||||
Stockholders equity: |
||||||||
Preferred stock 9,940,000 shares authorized; $.01 par value per share; none issued |
| | ||||||
Common stock 3 billion shares authorized; $.01 par value per share; 1,392,091,544 shares issued |
14 | 14 | ||||||
Additional paid-in capital |
2,278 | 2,214 | ||||||
Retained earnings |
7,149 | 6,735 | ||||||
Treasury stock, at cost 230,052,516 shares at September 30, 2009 and 234,991,565 shares at December 31, 2008 |
(4,292 | ) | (4,349 | ) | ||||
Accumulated other comprehensive loss |
(246 | ) | (553 | ) | ||||
Total stockholders equity |
4,903 | 4,061 | ||||||
Total liabilities and stockholders equity |
$ | 67,984 | $ | 51,675 | ||||
See Notes to Condensed Consolidated Financial Statements.
- 2 -
THE CHARLES SCHWAB CORPORATION
Condensed Consolidated Statements of Cash Flows
(In millions)
(Unaudited)
Nine Months Ended September 30, |
||||||||
2009 | 2008 | |||||||
Cash Flows from Operating Activities |
||||||||
Net income |
$ | 623 | $ | 904 | ||||
Adjustments to reconcile net income to net cash provided by (used for) operating activities: |
||||||||
Loss from discontinued operations, net of tax |
| 18 | ||||||
Depreciation and amortization expense |
121 | 113 | ||||||
Stock-based compensation expense |
54 | 49 | ||||||
Excess tax benefits from stock-based compensation |
(7 | ) | (47 | ) | ||||
Net impairment losses on securities |
38 | 44 | ||||||
Other |
(19 | ) | 20 | |||||
Originations of loans held for sale |
(2,279 | ) | (1,316 | ) | ||||
Proceeds from sales of loans held for sale |
2,264 | 1,305 | ||||||
Net change in: |
||||||||
Cash and investments segregated and on deposit for regulatory purposes |
(2,754 | ) | (4,951 | ) | ||||
Other securities owned |
(39 | ) | (319 | ) | ||||
Receivables from brokers, dealers, and clearing organizations |
189 | (310 | ) | |||||
Receivables from brokerage clients |
(751 | ) | 1,701 | |||||
Other assets |
11 | 7 | ||||||
Payables to brokers, dealers, and clearing organizations |
195 | 524 | ||||||
Payables to brokerage clients |
3,187 | 1,224 | ||||||
Accrued expenses and other liabilities |
(133 | ) | 322 | |||||
Net cash provided by (used for) operating activities |
700 | (712 | ) | |||||
Cash Flows from Investing Activities |
||||||||
Purchases of securities available for sale |
(11,144 | ) | (7,566 | ) | ||||
Proceeds from sales of securities available for sale |
107 | | ||||||
Principal payments on securities available for sale |
4,613 | 1,335 | ||||||
Purchases of securities held to maturity |
(2,808 | ) | | |||||
Principal payments on securities held to maturity |
73 | | ||||||
Net increase in loans to banking clients |
(921 | ) | (2,111 | ) | ||||
Purchase of equipment, office facilities, and property |
(108 | ) | (128 | ) | ||||
Other investing activities |
| (5 | ) | |||||
Net cash used for investing activities |
(10,188 | ) | (8,475 | ) | ||||
Cash Flows from Financing Activities |
||||||||
Net change in deposits from banking clients |
11,659 | 8,137 | ||||||
Issuance of long-term debt |
747 | | ||||||
Repayment of long-term debt |
(79 | ) | (19 | ) | ||||
Excess tax benefits from stock-based compensation |
7 | 47 | ||||||
Dividends paid |
(209 | ) | (185 | ) | ||||
Purchase of treasury stock |
| (350 | ) | |||||
Proceeds from stock options exercised and other |
46 | 116 | ||||||
Other financing activities |
(9 | ) | | |||||
Net cash provided by financing activities |
12,162 | 7,746 | ||||||
Increase (decrease) in Cash and Cash Equivalents |
2,674 | (1,441 | ) | |||||
Cash and Cash Equivalents at Beginning of Period |
5,442 | 6,764 | ||||||
Cash and Cash Equivalents at End of Period |
$ | 8,116 | $ | 5,323 | ||||
Supplemental Cash Flow Information |
||||||||
Cash paid during the period for: |
||||||||
Interest |
$ | 111 | $ | 184 | ||||
Income taxes |
$ | 350 | $ | 626 |
See Notes to Condensed Consolidated Financial Statements.
- 3 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
1. | Basis of Presentation |
The Charles Schwab Corporation (CSC) is a savings and loan holding company engaged, through its subsidiaries, in securities brokerage, banking, and related financial services. Charles Schwab & Co., Inc. (Schwab) is a securities broker-dealer with 304 domestic branch offices in 45 states, as well as a branch in each of the Commonwealth of Puerto Rico and London, U.K. In addition, Schwab serves clients in Hong Kong through one of CSCs subsidiaries. Other subsidiaries include Charles Schwab Bank (Schwab Bank), a federal savings bank, and Charles Schwab Investment Management, Inc. (CSIM), the investment advisor for Schwabs proprietary mutual funds, which are referred to as the Schwab Funds®.
The accompanying unaudited condensed consolidated financial statements include CSC and its majority-owned subsidiaries (collectively referred to as the Company). All material intercompany balances and transactions have been eliminated. These condensed consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the U.S. (GAAP), which require management to make certain estimates and assumptions that affect the reported amounts in the accompanying financial statements. Certain estimates include other-than-temporary impairment of securities available for sale and securities held to maturity, the valuation of goodwill, the allowance for credit losses, and legal reserves. Actual results could differ from those estimates. These condensed consolidated financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature. Certain prior-year amounts have been reclassified to conform to the 2009 presentation. These condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2008. The Companys results for any interim period are not necessarily indicative of results for a full year or any other interim period.
Management has evaluated subsequent events through the date the condensed consolidated financial statements were issued, which was November 5, 2009.
2. | New Accounting Standards |
Adoption of New Accounting Standards
Statement of Financial Accounting Standards (SFAS) No. 168 The Financial Accounting Standards Board (FASB) Accounting Standards Codification and the Hierarchy of GAAP, was effective for interim and annual reporting periods ending after September 15, 2009. This standard establishes the FASB Accounting Standards Codification (ASC or the Codification) as the source of authoritative accounting principles in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. New accounting standards will be issued as Accounting Standards Updates which will serve to update the Codification. The adoption of the Codification changed the Companys references to GAAP standards but did not have an impact on the Companys financial position, results of operations, earnings per share (EPS), or cash flows. This standard is part of ASC 105 GAAP.
SFAS No. 141R Business Combinations (ASC 805 Business Combinations), was effective beginning January 1, 2009. This standard generally requires an acquirer to recognize the assets acquired, the liabilities assumed, contingent purchase consideration, and any noncontrolling interest in the acquiree, at fair value on the date of acquisition. This standard also requires an acquirer to expense most transaction and restructuring costs as incurred, and not include such items in the cost of the acquired entity. This standard applies to any business acquisition with an acquisition date on or after January 1, 2009.
SFAS No. 160 Noncontrolling Interests in Consolidated Financial Statements (ASC 810 Consolidation), was effective beginning January 1, 2009. This standard amends financial statement presentation and disclosure requirements for reporting noncontrolling ownership interests. This standard also establishes consistent accounting methods for changes in ownership interest and for the valuation of retained noncontrolling investments upon deconsolidation. The adoption of this standard did not have a material impact on the Companys financial position, results of operations, EPS, or cash flows.
- 4 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
SFAS No. 161 Disclosures about Derivative Instruments and Hedging Activities (ASC 815 Derivatives and Hedging), was effective beginning January 1, 2009. This standard amends the disclosure requirements for qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair values and gains and losses on derivative instruments, and disclosures about credit-risk related contingent features in derivative agreements. This standard does not require any new derivative or hedging measurements. The adoption of this standard did not have a material impact to the Companys disclosures about derivative instruments and hedging activities.
SFAS No. 165 Subsequent Events (ASC 855 Subsequent Events), was effective for interim and annual reporting periods ending after June 15, 2009. This standard establishes the accounting for and disclosure of subsequent events. The Company adopted this standard in the second quarter of 2009, and the adoption did not have a material impact on the Companys financial position, results of operations, EPS or cash flows. See note 1 Basis of Presentation, for disclosures pursuant to this standard.
FASB Staff Position (FSP) on Emerging Issues Task Force Issue 03-6-1 Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (ASC 260 Earnings Per Share), was effective beginning January 1, 2009. This standard requires the inclusion of unvested share-based payment awards with non-forfeitable rights to dividends or dividend equivalents as participating securities in the computation of EPS under the two-class method. This standard requires retrospective adjustment to all prior-period EPS data presented. The Company does have participating securities in the form of unvested restricted common shares related to the Companys stock incentive plans. However, these participating securities do not have a material impact on the Companys EPS data presented.
FSP on SFAS No. 115-2 and SFAS No. 124-2 Recognition and Presentation of Other-Than-Temporary Impairments, was effective for interim and annual reporting periods ending after June 15, 2009 (ASC 320 Investments Debt and Equity Securities), with early adoption permitted for interim periods ending after March 15, 2009. This standard modifies the requirements for recognizing impairment charges on other-than-temporarily impaired (OTTI) debt securities and expands the disclosures related to OTTI debt and equity securities. The Company adopted this standard in the first quarter of 2009. See note 3 Securities Available for Sale and Securities Held to Maturity, for additional information and disclosures pursuant to this standard.
FSP on SFAS No. 157-4 Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That are Not Orderly (ASC 820 Fair Value Measurements and Disclosures), was effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. This standard provides additional guidance for estimating fair value when the volume and level of activity for an asset or liability have significantly decreased, including guidance on identifying circumstances that indicate a transaction is not orderly. This standard also requires additional disclosures related to fair value. The Company adopted this standard in the first quarter of 2009, and the adoption did not have a material impact on the Companys financial position, results of operations, EPS or cash flows. See note 7 Fair Values of Assets and Liabilities, for disclosures pursuant to this standard.
FSP on SFAS 107-1 and Accounting Principles Board Opinion 28-1 Interim Disclosures About Fair Value of Financial Instruments (ASC 820 Fair Value Measurements and Disclosures), was effective for interim and annual reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. This standard expands the fair value disclosures required for financial instruments to interim periods and requires entities to disclose the methods and significant assumptions used to estimate the fair value of financial instruments in financial statements on an interim and annual basis and to highlight any changes from prior periods. The Company adopted this standard in the first quarter of 2009. See note 7 Fair Values of Assets and Liabilities, for disclosures pursuant to this standard.
New Accounting Standards Not Yet Adopted
SFAS No. 166 Accounting for Transfers of Financial Assets, was issued in June 2009 and is effective for financial asset transfers occurring after January 1, 2010. This standard removes the concept of a qualifying special-purpose entity and amends the requirements for a transfer of a portion of a financial asset to be accounted for as a sale and related disclosures. The adoption of this standard is not expected to have a material impact on the Companys financial position, results of operations, EPS, or cash flows. This standard will update ASC 810 Consolidation.
- 5 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
SFAS No. 167 Amendments to FASB Interpretation No. 46(R), was issued in June 2009 and is effective January 1, 2010. This standard amends the consolidation guidance applicable to variable interest entities (VIEs), including changing the approach to determining a VIEs primary beneficiary (the reporting entity that must consolidate the VIE) and the frequency of reassessment. The Company is currently evaluating the impact of the adoption of this standard on its financial position, results of operations, EPS, and cash flows. This standard will update ASC 810 Consolidation.
Accounting Standards Update (ASU) 2009-05 Measuring Liabilities at Fair Value (ASC 820 Fair Value Measurements and Disclosures), was issued in August 2009 and is effective for interim and annual reporting periods beginning after the issuance date of ASU 2009-5. This standard clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement for that liability when no adjustment to the quoted price is required. In the absence of a Level 1 measurement, an entity must use either a valuation technique that uses a quoted price of an identical or similar liability when traded as an asset, or another valuation technique that is consistent with the principles of fair value measurements. The adoption of this standard is not expected to have a material impact on the Companys financial position, results of operations, EPS, or cash flows.
3. | Securities Available for Sale and Securities Held to Maturity |
The amortized cost, gross unrealized gains and losses, and fair value of securities available for sale and securities held to maturity are as follows:
September 30, 2009 |
Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | ||||||||
Securities available for sale: |
||||||||||||
U.S. agency residential mortgage-backed securities |
$ | 10,487 | $ | 205 | $ | 56 | $ | 10,636 | ||||
U.S. agency notes |
3,645 | 7 | 1 | 3,651 | ||||||||
Corporate debt securities |
2,519 | 16 | 1 | 2,534 | ||||||||
Non-agency residential mortgage-backed securities |
2,461 | | 585 | 1,876 | ||||||||
Certificates of deposit |
1,425 | 2 | | 1,427 | ||||||||
Asset-backed securities |
1,164 | 12 | | 1,176 | ||||||||
Total securities available for sale |
$ | 21,701 | $ | 242 | $ | 643 | $ | 21,300 | ||||
Securities held to maturity: |
||||||||||||
Asset-backed securities |
$ | 1,425 | $ | 30 | $ | | $ | 1,455 | ||||
U.S. agency residential mortgage-backed securities |
1,229 | 34 | | 1,263 | ||||||||
Corporate debt securities |
325 | 6 | | 331 | ||||||||
Total securities held to maturity |
$ | 2,979 | $ | 70 | $ | | $ | 3,049 | ||||
- 6 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
December 31, 2008 |
Amortized Cost |
Gross Unrealized Gains |
Gross Unrealized Losses |
Fair Value | ||||||||
Securities available for sale: |
||||||||||||
U.S. agency residential mortgage-backed securities |
$ | 8,203 | $ | 108 | $ | 82 | $ | 8,229 | ||||
U.S. agency notes |
515 | 2 | | 517 | ||||||||
Corporate debt securities |
1,762 | 2 | 31 | 1,733 | ||||||||
Non-agency residential mortgage-backed securities |
3,085 | | 862 | 2,223 | ||||||||
Certificates of deposit |
925 | | 3 | 922 | ||||||||
Asset-backed securities |
866 | | 44 | 822 | ||||||||
Total securities available for sale |
$ | 15,356 | $ | 112 | $ | 1,022 | $ | 14,446 | ||||
Securities held to maturity: |
||||||||||||
Asset-backed securities |
$ | 243 | $ | 1 | $ | | $ | 244 | ||||
Total securities held to maturity |
$ | 243 | $ | 1 | $ | | $ | 244 | ||||
A summary of securities with unrealized losses, aggregated by category and period of continuous unrealized loss, is as follows:
Less than 12 months | 12 months or longer | Total | ||||||||||||||||
September 30, 2009 |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses | ||||||||||||
Securities available for sale: |
||||||||||||||||||
U.S. agency residential mortgage-backed securities |
$ | 2,085 | $ | 24 | $ | 2,099 | $ | 32 | $ | 4,184 | $ | 56 | ||||||
U.S. agency notes |
399 | 1 | | | 399 | 1 | ||||||||||||
Corporate debt securities |
274 | 1 | | | 274 | 1 | ||||||||||||
Non-agency residential mortgage-backed securities |
| | 1,862 | 585 | 1,862 | 585 | ||||||||||||
Total securities with unrealized losses (1) |
$ | 2,758 | $ | 26 | $ | 3,961 | $ | 617 | $ | 6,719 | $ | 643 | ||||||
(1) The number of investment positions with unrealized losses totaled 311. | ||||||||||||||||||
Less than 12 months | 12 months or longer | Total | ||||||||||||||||
December 31, 2008 |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses |
Fair Value |
Unrealized Losses | ||||||||||||
Securities available for sale: |
||||||||||||||||||
U.S. agency residential mortgage-backed securities |
$ | 2,231 | $ | 63 | $ | 381 | $ | 19 | $ | 2,612 | $ | 82 | ||||||
Corporate debt securities |
477 | 11 | 436 | 20 | 913 | 31 | ||||||||||||
Non-agency residential mortgage-backed securities |
1,704 | 512 | 513 | 350 | 2,217 | 862 | ||||||||||||
Certificates of deposit |
647 | 3 | | | 647 | 3 | ||||||||||||
Asset-backed securities |
822 | 44 | | | 822 | 44 | ||||||||||||
Total securities with unrealized losses (1) |
$ | 5,881 | $ | 633 | $ | 1,330 | $ | 389 | $ | 7,211 | $ | 1,022 | ||||||
(1) | The number of investment positions with unrealized losses totaled 372. |
Unrealized losses in securities available for sale were $643 million as of September 30, 2009, and were concentrated in non-agency residential mortgage-backed securities. U.S. agency residential mortgage-backed securities do not have explicit credit ratings, however management considers these to be of the highest credit quality given the guarantee of principal and interest by the U.S. agencies. Included in non-agency residential mortgage-backed securities are securities collateralized by loans that are considered to be Prime (defined as loans to borrowers with a Fair Isaac & Company credit score of 620 or higher at origination), and Alt-A (defined as Prime loans with reduced documentation at origination). At September 30, 2009, the
- 7 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
amortized cost and fair value of Alt-A mortgage-backed securities were $672 million and $393 million, respectively. Corporate debt securities at September 30, 2009, included $983 million of securities issued by financial institutions and guaranteed under the Federal Deposit Insurance Corporation (FDIC) Temporary Liquidity Guarantee Program.
Assessment of Other-Than-Temporary Impairment
Management evaluates whether securities available for sale and securities held to maturity are OTTI on a quarterly basis. Debt securities with unrealized losses are considered OTTI if the Company intends to sell the security or if the Company will be required to sell such security prior to any anticipated recovery. If management determines that a security is OTTI under these circumstances, the impairment recognized in earnings is measured as the entire difference between the amortized cost and then-current fair value. A security is also OTTI if management does not expect to recover the amortized cost of the security. However in this circumstance, if the Company does not intend to sell the security and will not be required to sell the security, management utilizes cash flow models to estimate the expected future cash flow from the securities and to assess the probability that the Company will experience a loss. In this circumstance, the impairment recognized in earnings equals the estimated credit losses as measured by the difference between the present value of expected cash flows and the amortized cost of the security. Expected cash flows are discounted using the securitys effective interest rate.
The evaluation of whether the Company expects to recover the amortized cost of a security is inherently judgmental. The evaluation includes the assessment of several bond performance indicators including: the portion of the underlying loans that are delinquent (30 days, 60 days, 90+ days), in bankruptcy, in foreclosure or converted to real estate owned; the actual amount of loss incurred on the underlying loans in which the property has been foreclosed and sold; the amount of credit support provided by the structure of the security available to absorb credit losses on the underlying loans; the current credit ratings issued by either Standard & Poors, Fitch Ratings, or Moodys; the current price and magnitude of the unrealized loss; and whether the Company has received all scheduled principal and interest payments. Management uses cash flow models to further assess the likelihood of other-than-temporary impairment for the Companys non-agency residential mortgage-backed securities. To develop the cash flow models, the Company uses forecasted loss severity, prepayment speeds (i.e. the rate at which the principal on underlying loans are paid down), and default rates over the securities remaining maturities.
Certain Alt-A and Prime mortgage-backed securities experienced deteriorating credit characteristics in the first nine months of 2009, including increased payment delinquencies and decreased prepayments due to the slowing of general economic activity and increased unemployment. Losses on foreclosures of underlying mortgages increased as a result of housing price declines. Forecasted home price fluctuations are an important variable in forecasting the expected loss severity and default rates. Based on the Companys cash flow projections, management determined that it does not expect to recover all of the amortized cost of these securities and therefore determined that these securities were OTTI. The Company does not intend to sell the securities available for sale and it will not be required to sell these securities before anticipated recovery. The Company employs a buy and hold strategy relative to its mortgage-related securities. Further, the Company has an adequate liquidity position at September 30, 2009, with cash and cash equivalents totaling $8.1 billion, a loan-to-deposit ratio of 19%, adequate access to short-term borrowing facilities and regulatory capital ratios in excess of well capitalized levels. Because the Company does not intend to sell these securities and will not be required to sell these securities, the Company recognized an impairment charge equal to the securities expected credit losses of $11 million and $38 million during the third quarter and first nine months of 2009, respectively. The expected credit losses were measured as the difference between the present value of expected cash flows and the amortized cost of the securities.
In the third quarter and first nine months of 2008, the Company recognized an other-than-temporary impairment charge of $44 million on corporate debt securities issued by Lehman Brothers Holdings, Inc. (Lehman) as a result of Lehmans Chapter 11 bankruptcy petition filing in September 2008. The Company sold these securities in October 2008. Impairment charges recognized in earnings are included in net impairment losses on securities.
As of September 30, 2009, the Company has not realized an actual credit loss on any of its residential mortgage-backed securities. Further deterioration in the performance of the underlying loans in the Companys residential mortgage-backed securities portfolio could result in the recognition of additional future impairment charges.
- 8 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
The following table is a rollforward of the amount of credit losses recognized in earnings for OTTI securities held by the Company during the period for which a portion of the impairment was recognized in other comprehensive income:
Three Months Ended September 30, 2009 |
Nine Months Ended September 30, 2009 | |||||
Balance at beginning of period |
$ | 27 | $ | | ||
Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was not previously recognized |
6 | 38 | ||||
Credit losses recognized into current period earnings on debt securities for which an other-than-temporary impairment was previously recognized |
5 | | ||||
Balance at end of period |
$ | 38 | $ | 38 | ||
The maturities of securities available for sale and securities held to maturity at September 30, 2009, are as follows:
Within 1 year |
After 1 year through 5 years |
After 5 years through 10 years |
After 10 years |
Total | |||||||||||
Securities available for sale: |
|||||||||||||||
U.S. agency residential mortgage-backed securities (1) |
$ | | $ | | $ | 188 | $ | 10,448 | $ | 10,636 | |||||
U.S. agency notes |
450 | 3,201 | | | 3,651 | ||||||||||
Corporate debt securities |
678 | 1,856 | | | 2,534 | ||||||||||
Non-agency residential mortgage-backed securities (1) |
| | 34 | 1,842 | 1,876 | ||||||||||
Certificates of deposit |
1,127 | 300 | | | 1,427 | ||||||||||
Asset-backed securities |
| 835 | 341 | | 1,176 | ||||||||||
Total fair value |
$ | 2,255 | $ | 6,192 | $ | 563 | $ | 12,290 | $ | 21,300 | |||||
Total amortized cost |
$ | 2,251 | $ | 6,167 | $ | 552 | $ | 12,731 | $ | 21,701 | |||||
Securities held to maturity: |
|||||||||||||||
Asset-backed securities |
$ | | $ | 1,196 | $ | 259 | $ | | $ | 1,455 | |||||
U.S. agency residential mortgage-backed securities (1) |
| | | 1,263 | 1,263 | ||||||||||
Corporate debt securities |
33 | 298 | | | 331 | ||||||||||
Total fair value |
$ | 33 | $ | 1,494 | $ | 259 | $ | 1,263 | $ | 3,049 | |||||
Total amortized cost |
$ | 33 | $ | 1,462 | $ | 255 | $ | 1,229 | $ | 2,979 | |||||
(1) | Mortgage-backed securities have been allocated over maturity groupings based on final contractual maturities. Actual maturities will differ from final contractual maturities because a certain portion of loans underlying these securities require scheduled principal payments and borrowers have the right to prepay obligations. |
The proceeds and gross realized gains (losses) from sales of securities available for sale are as follows:
Three Months Ended September 30, |
Nine Months Ended September 30, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Proceeds |
$ | 22 | $ | | $ | 107 | $ | | ||||||||
Gross realized gains |
$ | | $ | | $ | 1 | $ | | ||||||||
Gross realized losses |
$ | (3 | ) | $ | (29 | ) | $ | (4 | ) | $ | (29 | ) |
Realized gains and losses from sales of securities available for sale are included in other revenue.
In the third quarter and first nine months of 2008, the Company recorded a loss of $29 million on the sale of corporate debt securities issued by Washington Mutual Bank as a result of its seizure by the FDIC in September 2008. The sale reflected
- 9 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
significant unanticipated changes in the financial condition of the issuer and did not impact the Companys ability and intent to hold remaining securities.
4. | Loans to Banking Clients and Related Allowance for Credit Losses |
The composition of the loan portfolio is as follows:
September 30, 2009 |
December 31, 2008 |
|||||||
Residential real estate mortgages |
$ | 3,450 | $ | 3,195 | ||||
Home equity lines of credit |
3,209 | 2,662 | ||||||
Secured personal loans |
274 | 187 | ||||||
Other |
24 | 20 | ||||||
Total loans to banking clients |
6,957 | 6,064 | ||||||
Allowance for credit losses |
(44 | ) | (20 | ) | ||||
Total loans to banking clients net |
$ | 6,913 | $ | 6,044 | ||||
Included in the loan portfolio are nonaccrual loans totaling $26 million and $8 million at September 30, 2009 and December 31, 2008, respectively. Nonperforming assets, which include nonaccrual loans and other real estate owned, totaled $28 million and $9 million at September 30, 2009 and December 31, 2008, respectively. There were no loans accruing interest that were contractually 90 days or more past due at September 30, 2009 or December 31, 2008. The amount of interest revenue that would have been earned on non-accrual loans, versus interest revenue recognized on these loans, was not material to the Companys results of operations for the first nine months of 2009 or 2008.
Changes in the allowance for credit losses were as follows:
Three Months Ended September 30, |
Nine Months Ended September 30, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Balance at beginning of period |
$ | 41 | $ | 12 | $ | 20 | $ | 7 | ||||||||
Charge-offs |
(4 | ) | (1 | ) | (9 | ) | (2 | ) | ||||||||
Recoveries |
| | | | ||||||||||||
Provision for credit losses |
7 | 5 | 33 | 11 | ||||||||||||
Balance at end of period |
$ | 44 | $ | 16 | $ | 44 | $ | 16 | ||||||||
5. | Long-term Debt |
Long-term debt net of unamortized debt discounts, where applicable, consists of the following:
September 30, 2009 |
December 31, 2008 | |||||
Senior Notes |
$ | 747 | $ | | ||
Senior Medium-Term Notes, Series A |
450 | 458 | ||||
Junior Subordinated Notes |
202 | 300 | ||||
Finance lease obligation |
113 | 116 | ||||
Fair value adjustment |
4 | 9 | ||||
Total long-term debt |
$ | 1,516 | $ | 883 | ||
- 10 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
In June 2009, the Company issued $750 million of Senior Notes that mature in 2014. The Senior Notes have a fixed interest rate of 4.950% with interest payable semiannually.
In the first nine months of 2009, the Company repurchased $98 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $67 million. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $31 million.
6. | Commitments and Contingent Liabilities |
The Company has clients that sell (i.e., write) listed option contracts that are cleared by various clearing houses. The clearing houses establish margin requirements on these transactions. The Company satisfies the margin requirements by arranging unsecured standby letter of credit agreements (LOCs), in favor of the clearing houses, which are issued by multiple banks. At September 30, 2009, the aggregate face amount of these LOCs totaled $445 million. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging LOCs, in favor of these brokerage clients, which are issued by multiple banks. At September 30, 2009, the aggregate face amount of these LOCs totaled $31 million. There were no funds drawn under any of these LOCs at September 30, 2009.
The Company also provides guarantees to securities clearing houses and exchanges under their standard membership agreement, which requires members to guarantee the performance of other members. Under the agreement, if another member becomes unable to satisfy its obligations to the clearing houses and exchanges, other members would be required to meet shortfalls. The Companys liability under these arrangements is not quantifiable and may exceed the cash and securities it has posted as collateral. However, the potential requirement for the Company to make payments under these arrangements is remote. Accordingly, no liability has been recognized for these transactions.
Legal contingencies: The Company is subject to claims and lawsuits in the ordinary course of business, including arbitrations, class actions and other litigation, some of which include claims for substantial or unspecified damages. The Company is also the subject of inquiries, investigations, and proceedings by regulatory and other governmental agencies. In addition, the Company is responding to certain litigation claims brought against former subsidiaries pursuant to indemnities it has provided to purchasers of those entities. Certain of these matters are described below.
The Company believes it has strong defenses in all significant matters currently pending and is contesting liability and the damages claimed. Nevertheless, some of these matters may result in adverse judgments or awards, including penalties, injunctions, or other relief, and the Company may also determine to settle a matter because of the uncertainty and risks of litigation. Based on current information and consultation with counsel, management believes that the resolution of matters currently pending will not have a material impact on the financial condition or cash flows of the Company, but could be material to the Companys operating results for a particular future period, depending on results for that period. However, predicting the outcome of a matter is inherently difficult, particularly where claims are brought on behalf of various classes of claimants, claimants seek substantial or unspecified damages, or when investigations or legal proceedings are at an early stage, and in many cases, including those matters described below, it is not possible to determine whether a loss will be incurred or to estimate the range of that loss until the matter is closer to resolution.
Auction Rate Securities Regulatory Inquiries: Schwab has been responding to industry wide inquiries from federal and state regulators regarding sales of auction rate securities to clients who were unable to sell their holdings when the normal auction process for those securities froze unexpectedly in February 2008. On August 17, 2009, a civil complaint was filed against Schwab in New York state court by the Attorney General of the State of New York (NYAG) alleging material misrepresentations and omissions by Schwab regarding the risks of auction rate securities, and seeking restitution, disgorgement, penalties and other relief, including repurchase of securities held in client accounts. As reflected in a statement issued August 17, 2009, Schwab has responded that the allegations are without merit and that Schwab intends to contest any charges. On September 5, 2009, Schwab removed the case to the U.S. District Court for the Southern District of New York; a motion by the NYAG to remand the case back to state court was filed on October 21, 2009, and remains pending.
- 11 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
YieldPlus Fund Litigation and Regulatory Inquiries: The Company is the subject of nine purported class action lawsuits filed between March and May 2008 on behalf of investors in the Schwab YieldPlus Fund® alleging violations of state law and federal securities law in connection with the funds investment policy, disclosures and fund marketing. Allegations include changes to the investment policy of the fund regarding limits on positions in mortgage-backed securities without obtaining a shareholder vote; inadequate disclosure of the risks associated with fund investments in mortgage-backed securities; inaccurate reporting of the funds weighted-average duration; and failure to disclose redemptions of positions in YieldPlus by other Schwab investment funds. Defendants named in one or more of the lawsuits include the Company, Schwab, CSIM, the fund itself, Schwab Investments (registrant and issuer of the funds shares), Charles R. Schwab, Randall W. Merk (current president of the fund), and current and former trustees and officers of the fund and/or Schwab. Claimants seek unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys fees. On July 3, 2008, the U.S. District Court for the Northern District of California consolidated all nine lawsuits into a single action for purposes of pre-trial proceedings and appointed a group of fund investors as lead plaintiff. On February 4, 2009, the court denied defendants motion to dismiss plaintiffs federal law claims, dismissed all but one state law claim, and lifted a stay on discovery. On August 21, 2009, the court certified two classes of plaintiffs for purposes of the federal law claims and a single class of plaintiffs for purposes of the remaining state law claim. On October 22, 2009, the court denied plaintiffs motion to amend the complaint to add an additional federal securities law claim, but allowed plaintiffs to amend their complaint to allege additional misrepresentations regarding fund risk management and asset liquidity.
Separately, the Company has been responding to investigations by federal and state regulators regarding these matters. On October 14, 2009, the Company received a Wells notice from the staff of the SEC that the staff intends to recommend the filing of a civil enforcement action against Schwab Investments, CSIM, Charles Schwab & Co., Inc., and the president of the fund for possible violations of the securities laws with respect to the fund. On October 27, 2009, the Company received a Wells notice from the Financial Industry Regulatory Authority (FINRA) regarding a preliminary determination to recommend disciplinary action against Charles Schwab & Co., Inc. for possible violation of securities laws and FINRA rules with respect to the fund. A Wells notice provides recipients an opportunity to respond to issues raised in an investigation prior to any decision on an enforcement proceeding, and is neither a formal allegation nor a finding of wrongdoing. The Company intends to respond to the notices to explain why it believes enforcement charges are unwarranted.
At this time the Company is unable to estimate whether it will incur a liability or the range of any such liability in these litigation and regulatory matters; if a liability were incurred, in view of claims to date under the Companys insurance policies, it is increasingly likely that such a liability would exceed the limits of applicable policies.
Total Bond Market Fund Litigation: On August 28, 2008, a class action lawsuit was filed in the U.S. District Court for the Northern District of California on behalf of investors in the Schwab Total Bond Market Fund. The lawsuit, which alleges violations of state law and federal securities law in connection with the funds investment policy, names the fund, Schwab Investments (registrant and issuer of the funds shares), Schwab, and CSIM as defendants. Allegations include that the fund improperly deviated from its stated investment objectives by investing in collateralized mortgage obligations (CMOs) and investing more than 25% of fund assets in CMOs and mortgage-backed securities without obtaining a shareholder vote. Claimants seek unspecified compensatory and rescission damages, unspecified equitable and injunctive relief, and costs and attorneys fees. On February 19, 2009, the court denied defendants motion to dismiss plaintiffs federal securities law claim, and dismissed certain state law claims with leave to amend. On April 27, 2009, the court issued a stay of proceedings while defendants appeal the courts February 19, 2009 decision refusing to dismiss plaintiffs federal securities law claim, currently under review by the U.S. Court of Appeals for the Ninth Circuit.
The SEC Wells notice received by the Company on October 14, 2009, concerning the YieldPlus Fund also provided notice of the SEC staffs intention to recommend additional charges against Schwab Investments and CSIM for possible violations of the securities laws with respect to the Total Bond Market Fund. The Company intends to respond to the notice to explain why it believes these additional enforcement charges are also unwarranted.
SoundView Litigation: On October 5, 2009, the United States District Court for the Southern District of New York granted final approval of a global settlement reached between plaintiffs and lead underwriters in consolidated class action litigation relating to allocation of shares in initial public offerings between March 1997 and December 2000 (IPO Allocation Litigation). As part of the sale of Schwab Capital Markets L.P. and all of the outstanding capital stock of SoundView Technology Group, Inc. (SoundView) to UBS Securities LLC and UBS Americas Inc. (collectively referred to as UBS), the
- 12 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
Company agreed to indemnify UBS for certain litigation, including this matter. The Companys liability for contribution amounts for SoundView entities under the settlement is not material.
7. | Fair Values of Assets and Liabilities |
SFAS No. 157 Fair Value Measurements (ASC 820 Fair Value Measurements and Disclosures) defines fair value as the price that would be received to sell an asset or the price paid to transfer a liability in an orderly transaction between market participants at the measurement date. This standard also establishes a hierarchy for disclosing assets and liabilities measured at fair value based on the inputs used to value them. The fair value hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. Observable inputs are based on market pricing data obtained from sources independent of the Company. A quoted price in an active market provides the most reliable evidence of fair value and is generally used to measure fair value whenever available. Unobservable inputs reflect managements judgment about the assumptions market participants would use in pricing the asset or liability. Where inputs used to measure fair value of an asset or liability are from different levels of the hierarchy, the asset or liability is categorized based on the lowest level input that is significant to the fair value measurement in its entirety. Assessing the significance of a particular input requires judgment. The fair value hierarchy includes three levels based on the objectivity of the inputs as follows:
| Level 1 inputs are quoted prices in active markets as of the measurement date for identical assets or liabilities that the Company has the ability to access. This category includes active exchange-traded money market funds, mutual funds, and equity securities. |
| Level 2 inputs are inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates, benchmark yields, issuer spreads, new issue data, and collateral performance. This category includes residential mortgage-backed securities, asset-backed securities, corporate debt securities, certificates of deposit, commercial paper, U.S. agency and municipal debt securities, U.S. Treasury securities, and derivative contracts. |
| Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. The Company did not have any financial assets or liabilities utilizing Level 3 inputs as of September 30, 2009 or December 31, 2008. |
Assets and Liabilities Recorded at Fair Value
The Companys assets recorded at fair value include certain investments segregated and on deposit for regulatory purposes, other securities owned, and securities available for sale. The Company uses prices obtained from an independent third-party pricing service to measure the fair value of certain investment securities. The Company validates prices received from the pricing service using various methods including comparison to prices received from additional pricing services, comparison to quoted market prices, where available, comparison to internal valuation models, and review of other relevant market data including implied yields of major categories of securities. The Company does not adjust the prices received from the independent third-party pricing service unless such prices are inconsistent with ASC 820 and result in a material difference in the recorded amounts. At September 30, 2009 and December 31, 2008, the Company did not adjust prices received from the independent third-party pricing service. Liabilities recorded at fair value are not material.
- 13 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
The following tables present the Companys fair value hierarchy for assets and liabilities measured at fair value:
September 30, 2009 |
Quoted Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
Balance at Fair Value | ||||||||
Assets |
||||||||||||
Investments segregated and on deposit for regulatory purposes |
||||||||||||
Certificates of deposit |
$ | | $ | 2,359 | $ | | $ | 2,359 | ||||
Corporate debt securities |
| 2,139 | | 2,139 | ||||||||
U.S. Government securities |
| 2,019 | | 2,019 | ||||||||
Commercial paper |
| 100 | | 100 | ||||||||
Total investments segregated and on deposit for regulatory purposes |
| 6,617 | | 6,617 | ||||||||
Other securities owned |
||||||||||||
Commercial paper |
| 250 | | 250 | ||||||||
Schwab Funds® money market funds |
220 | | | 220 | ||||||||
Equity and bond mutual funds |
98 | | | 98 | ||||||||
State and municipal debt obligations |
| 66 | | 66 | ||||||||
Equity, U.S. Government and corporate debt, and other securities |
2 | 29 | | 31 | ||||||||
Total other securities owned |
320 | 345 | | 665 | ||||||||
Securities available for sale |
||||||||||||
U.S. agency residential mortgage-backed securities |
| 10,636 | | 10,636 | ||||||||
U.S. agency notes |
| 3,651 | | 3,651 | ||||||||
Corporate debt securities |
| 2,534 | | 2,534 | ||||||||
Non-agency residential mortgage-backed securities |
| 1,876 | | 1,876 | ||||||||
Certificates of deposit |
| 1,427 | | 1,427 | ||||||||
Asset-backed securities |
| 1,176 | | 1,176 | ||||||||
Total securities available for sale |
| 21,300 | | 21,300 | ||||||||
Other assets (1) |
| 5 | | 5 | ||||||||
Total assets at fair value |
$ | 320 | $ | 28,267 | $ | | $ | 28,587 | ||||
Liabilities |
||||||||||||
Accrued expenses and other liabilities (2) |
$ | 1 | $ | 2 | $ | | $ | 3 | ||||
(1) | Other assets recorded at fair value include derivative contracts. |
(2) | Accrued expenses and other liabilities include securities sold, not yet purchased, and derivative contracts. |
- 14 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
December 31, 2008 |
Quoted Prices in Active Markets for Identical Assets (Level 1) |
Significant Other Observable Inputs (Level 2) |
Significant Unobservable Inputs (Level 3) |
Balance at Fair Value | ||||||||
Assets |
||||||||||||
Investments segregated and on deposit for regulatory purposes |
||||||||||||
Certificates of deposit |
$ | | $ | 3,888 | $ | | $ | 3,888 | ||||
Corporate debt securities |
| 1,501 | | 1,501 | ||||||||
U.S. Government securities |
| 1,190 | | 1,190 | ||||||||
Commercial paper |
| 250 | | 250 | ||||||||
Total investments segregated and on deposit for regulatory purposes |
| 6,829 | | 6,829 | ||||||||
Other securities owned |
||||||||||||
Schwab Funds® money market funds |
440 | | | 440 | ||||||||
Equity and bond mutual funds |
135 | | | 135 | ||||||||
State and municipal debt obligations |
| 37 | | 37 | ||||||||
Equity, U.S. Government and corporate debt, and other securities |
3 | 11 | | 14 | ||||||||
Total other securities owned |
578 | 48 | | 626 | ||||||||
Securities available for sale |
||||||||||||
U.S. agency residential mortgage-backed securities |
| 8,229 | | 8,229 | ||||||||
U.S. agency notes |
| 517 | | 517 | ||||||||
Corporate debt securities |
| 1,733 | | 1,733 | ||||||||
Non-agency residential mortgage-backed securities |
| 2,223 | | 2,223 | ||||||||
Certificates of deposit |
| 922 | | 922 | ||||||||
Asset-backed securities |
| 822 | | 822 | ||||||||
Total securities available for sale |
| 14,446 | | 14,446 | ||||||||
Other assets (1) |
| 11 | | 11 | ||||||||
Total assets at fair value |
$ | 578 | $ | 21,334 | $ | | $ | 21,912 | ||||
Liabilities |
||||||||||||
Accrued expenses and other liabilities (2) |
$ | 2 | $ | 3 | $ | | $ | 5 | ||||
(1) | Other assets recorded at fair value include derivative contracts. |
(2) | Accrued expenses and other liabilities include securities sold, not yet purchased, and derivative contracts. |
Fair Value of Assets and Liabilities Not Recorded at Fair Value
Descriptions of the valuation methodologies and assumptions used to estimate the fair value of assets and liabilities not recorded at fair value are described below. There were no significant changes in these methodologies or assumptions during the first nine months of 2009.
Cash and cash equivalents, receivables, payables, and accrued expenses and other liabilities include cash and highly liquid investments, receivables and payables from/ to brokers, dealers and clearing organizations, receivables and payables from/ to brokerage clients, and drafts, accounts, taxes, interest, and compensation payable. Assets and liabilities in these categories are short-term in nature and accordingly are recorded at amounts that approximate fair value.
Cash and investments segregated and on deposit for regulatory purposes include securities purchased under resale agreements. Securities purchased under resale agreements are recorded at par value plus accrued interest. Securities purchased under resale agreements are short-term in nature and are backed by collateral that both exceeds the carrying value of the resale agreement and is highly liquid in nature. Accordingly, the carrying value approximates fair value.
Securities held to maturity include asset-backed securities collateralized by credit card, student, and auto loans and U.S. agency residential mortgage-backed securities. Securities held to maturity are recorded at amortized cost. The fair value of these securities is obtained using an independent third-party pricing service, as discussed above.
- 15 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
Loans to banking clients primarily include adjustable rate residential first-mortgage and home equity lines of credit (HELOC) loans. Loans to banking clients are recorded at carrying value net of an allowance for credit losses. The fair value of the Companys loans to banking clients is estimated based on market prices for mortgage-backed securities collateralized by similar types of loans.
Loans held for sale include fixed rate residential first-mortgage and HELOC loans. Loans held for sale are recorded at the lower of cost or fair value. The fair value of the Companys loans held for sale is estimated using quoted market prices for securities backed by similar types of loans.
Other assets include cost method investments, including the Companys investment in Federal Home Loan Bank (FHLB) stock. The cost method investments carrying values approximate their fair values.
Deposits from banking clients: The Company considers the fair value of deposits with no stated maturity, such as deposits from banking clients, to be equal to the amount payable on demand as of the balance sheet date.
Long-term debt includes Senior Notes, Medium-Term Notes, and Junior Subordinated Notes, and a finance lease obligation. The fair value of the Companys long-term debt is estimated using indicative, non-binding quotes from independent brokers.
Firm commitments to extend credit: The Company extends credit to banking clients through HELOC commitments. The Company considers the fair value of unused HELOC commitments to be not material because the interest rate earned on HELOC outstanding balances is based on the Prime rate and resets monthly. Future utilization of HELOC commitments will earn a then-current market interest rate. The Company does not charge a fee to maintain a HELOC.
The table below presents the Companys fair value estimates for financial instruments excluding short-term financial assets and liabilities, for which carrying amounts approximate fair value, and excluding financial instruments recorded at fair value.
September 30, 2009 |
December 31, 2008 | |||||||||||
Carrying Amount |
Fair Value |
Carrying Amount |
Fair Value | |||||||||
Financial Assets: |
||||||||||||
Securities held to maturity |
$ | 2,979 | $ | 3,049 | $ | 243 | $ | 244 | ||||
Loans to banking clients net |
$ | 6,913 | $ | 6,362 | $ | 6,044 | $ | 5,389 | ||||
Loans held for sale |
$ | 66 | $ | 67 | $ | 41 | $ | 42 | ||||
Financial Liabilities: |
||||||||||||
Long-term debt |
$ | 1,516 | $ | 1,578 | $ | 883 | $ | 705 |
- 16 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
8. | Comprehensive Income and Accumulated Other Comprehensive Loss |
The components of comprehensive income are as follows:
Three Months Ended September 30, |
Nine Months Ended September 30, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Net income |
$ | 200 | $ | 304 | $ | 623 | $ | 904 | ||||||||
Other comprehensive income (loss): |
||||||||||||||||
Change in net unrealized gain (loss) on securities available for sale: |
||||||||||||||||
Unrealized gain (loss) on Non-OTTI securities |
241 | (306 | ) | 585 | (513 | ) | ||||||||||
Unrealized loss on OTTI securities |
(64 | ) | | (116 | ) | | ||||||||||
OTTI charges recognized in earnings |
11 | 44 | 38 | 44 | ||||||||||||
Reclassification of realized loss included in earnings |
3 | 29 | 3 | 29 | ||||||||||||
Income tax effect |
(75 | ) | 91 | (203 | ) | 173 | ||||||||||
Net |
116 | (142 | ) | 307 | (267 | ) | ||||||||||
Foreign currency translation adjustment |
| (1 | ) | | (1 | ) | ||||||||||
Total other comprehensive income (loss) |
116 | (143 | ) | 307 | (268 | ) | ||||||||||
Comprehensive income |
$ | 316 | $ | 161 | $ | 930 | $ | 636 | ||||||||
Accumulated other comprehensive loss represents cumulative gains and losses that are not reflected in earnings. Accumulated other comprehensive loss balances were:
Net unrealized loss on securities available for sale |
||||||||||||||||
Portion of unrealized loss on Non-OTTI securities |
Portion of unrealized loss on OTTI securities |
Foreign currency translation adjustment |
Total accumulated other comprehensive loss |
|||||||||||||
Balance at December 31, 2007 |
$ | (18 | ) | $ | | $ | 1 | $ | (17 | ) | ||||||
Net change |
(267 | ) | | (1 | ) | (268 | ) | |||||||||
Balance at September 30, 2008 |
$ | (285 | ) | $ | | $ | | $ | (285 | ) | ||||||
Balance at December 31, 2008 |
$ | (553 | ) | $ | | $ | | $ | (553 | ) | ||||||
Reclassification of OTTI securities |
121 | (121 | ) | | | |||||||||||
Other net changes |
307 | | | 307 | ||||||||||||
Balance at September 30, 2009 |
$ | (125 | ) | $ | (121 | ) | $ | | $ | (246 | ) | |||||
- 17 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
9. | Earnings Per Share |
Basic EPS is computed by dividing net income available to common shareholders by the weighted-average number of common shares outstanding during the period. The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued. Dilutive potential common shares are determined using the treasury stock method, and include outstanding stock options and unvested restricted stock awards. EPS under the basic and diluted computations are as follows:
Three Months Ended September 30, |
Nine Months Ended September 30, |
||||||||||||
2009 | 2008 | 2009 | 2008 | ||||||||||
Net income available to common shareholders (1) |
$ | 200 | $ | 304 | $ | 623 | $ | 904 | |||||
Weighted-average common shares outstanding basic |
1,157 | 1,148 | 1,155 | 1,147 | |||||||||
Common stock equivalent shares related to stock incentive plans |
6 | 10 | 5 | 10 | |||||||||
Weighted-average common shares outstanding diluted (2) |
1,163 | 1,158 | 1,160 | 1,157 | |||||||||
Basic EPS: |
|||||||||||||
Income from continuing operations |
$ | .17 | $ | .26 | $ | .54 | $ | .80 | |||||
Loss from discontinued operations, net of tax |
$ | | $ | | $ | | $ | (.01 | ) | ||||
Net income |
$ | .17 | $ | .26 | $ | .54 | $ | .79 | |||||
Diluted EPS: |
|||||||||||||
Income from continuing operations |
$ | .17 | $ | .26 | $ | .54 | $ | .80 | |||||
Loss from discontinued operations, net of tax |
$ | | $ | | $ | | $ | (.02 | ) | ||||
Net income |
$ | .17 | $ | .26 | $ | .54 | $ | .78 |
(1) | Net income available to participating securities (unvested restricted shares) was not material for the third quarters and first nine months of 2009 or 2008. |
(2) | Total antidilutive stock options and restricted stock awards excluded from the calculation of diluted EPS were 28 million and 19 million shares for the third quarters of 2009 and 2008, respectively, and 35 million and 22 million shares for the first nine months of 2009 and 2008, respectively. |
10. | Regulatory Requirements |
CSC is a savings and loan holding company and Schwab Bank, CSCs depository institution subsidiary, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision. As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries business activities, and the risks inherent in those activities.
Schwab Bank is required to maintain a capital level that at least equals minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. At September 30, 2009, CSC and Schwab Bank met the capital level requirements.
- 18 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
The regulatory capital and ratios for Schwab Bank at September 30, 2009, are as follows:
Actual | Minimum Capital Requirement |
Minimum to be Well Capitalized |
||||||||||||||||
Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||
Tier 1 Capital |
$ | 2,454 | 17.0 | % | $ | 578 | 4.0 | % | $ | 868 | 6.0 | % | ||||||
Total Capital |
$ | 2,498 | 17.3 | % | $ | 1,157 | 8.0 | % | $ | 1,446 | 10.0 | % | ||||||
Leverage |
$ | 2,454 | 6.4 | % | $ | 1,538 | 4.0 | % | $ | 1,922 | 5.0 | % | ||||||
Tangible Equity |
$ | 2,454 | 6.4 | % | $ | 769 | 2.0 | % | N/A |
N/A Not applicable.
Based on its regulatory capital ratios at September 30, 2009, Schwab Bank is considered well capitalized (the highest category) pursuant to banking regulatory guidelines. There are no conditions or events since September 30, 2009, that management believes have changed Schwab Banks capital category.
Schwab is subject to Rule 15c3-1 under the Securities Exchange Act of 1934 (the Uniform Net Capital Rule). Schwab computes net capital under the alternative method permitted by the Uniform Net Capital Rule. This method requires the maintenance of minimum net capital, as defined, of the greater of 2% of aggregate debit balances arising from client transactions or a minimum dollar requirement, which is based on the type of business conducted by the broker-dealer. At September 30, 2009, 2% of aggregate debits was $182 million, which exceeded the minimum dollar requirement for Schwab of $250,000. At September 30, 2009, Schwabs net capital was $1.1 billion (12% of aggregate debit balances), which was $897 million in excess of its minimum required net capital and $624 million in excess of 5% of aggregate debit balances. Under the alternative method, a broker-dealer may not repay subordinated borrowings, pay cash dividends, or make any unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement.
11. | Segment Information |
The Company structures its segments according to its various types of clients and the services provided to those clients. The Companys two reportable segments are Investor Services and Institutional Services. As a result of organizational and related business changes in the first quarter of 2009, the segments formerly reported as Advisor Services and Corporate and Retirement Services were combined into a single segment called Institutional Services. Previously-reported segment information has been revised to reflect this change. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and other significant restructuring charges. Segment assets and liabilities are not disclosed because the balances are not used for evaluating segment performance and deciding how to allocate resources to segments. There are no revenues from transactions with other segments within the Company.
- 19 -
THE CHARLES SCHWAB CORPORATION
Notes to Condensed Consolidated Financial Statements
(Tabular Amounts in Millions, Except Per Share Data, Ratios, or as Noted)
(Unaudited)
Financial information for the Companys reportable segments is presented in the following table:
Three Months Ended September 30, |
Nine Months Ended September 30, |
|||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||
Net revenues: |
||||||||||||||||
Investor Services |
$ | 658 | $ | 820 | $ | 2,069 | $ | 2,557 | ||||||||
Institutional Services |
353 | 428 | 1,138 | 1,299 | ||||||||||||
Unallocated |
| 3 | | 10 | ||||||||||||
Total net revenues |
$ | 1,011 | $ | 1,251 | $ | 3,207 | $ | 3,866 | ||||||||
Income from continuing operations before taxes on income: |
||||||||||||||||
Investor Services |
$ | 196 | $ | 315 | $ | 654 | $ | 969 | ||||||||
Institutional Services |
125 | 185 | 443 | 552 | ||||||||||||
Unallocated |
(1 | ) | (1 | ) | (87 | ) | | |||||||||
Income from continuing operations before taxes on income |
320 | 499 | 1,010 | 1,521 | ||||||||||||
Taxes on income |
(120 | ) | (195 | ) | (387 | ) | (599 | ) | ||||||||
Loss from discontinued operations, net of tax |
| | | (18 | ) | |||||||||||
Net income |
$ | 200 | $ | 304 | $ | 623 | $ | 904 | ||||||||
- 20 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Item 2. | Managements Discussion and Analysis of Financial Condition and Results of Operations |
OVERVIEW
Management of The Charles Schwab Corporation (CSC) and its subsidiaries (collectively referred to as the Company) focuses on several key financial and non-financial metrics in evaluating the Companys financial position and operating performance. Results for the third quarters and first nine months of 2009 and 2008 are shown in the following table:
Three Months Ended September 30, |
Percent Change |
Nine Months Ended September 30, |
Percent Change |
|||||||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||||||||
Client Activity Metrics: |
||||||||||||||||||||||
Net new client assets (in billions) |
$ | 19.9 | $ | 24.4 | (18 | %) | $ | 62.5 | $ | 91.7 | (32 | %) | ||||||||||
Client assets (in billions, at quarter end) |
$ | 1,363.6 | $ | 1,304.5 | 5 | % | ||||||||||||||||
Clients daily average trades (in thousands) |
318.5 | 334.8 | (5 | %) | 342.2 | 320.3 | 7 | % | ||||||||||||||
Company Financial Metrics: |
||||||||||||||||||||||
Net revenues |
$ | 1,011 | $ | 1,251 | (19 | %) | $ | 3,207 | $ | 3,866 | (17 | %) | ||||||||||
Expenses excluding interest |
691 | 752 | (8 | %) | 2,197 | 2,345 | (6 | %) | ||||||||||||||
Income from continuing operations before taxes on income |
320 | 499 | (36 | %) | 1,010 | 1,521 | (34 | %) | ||||||||||||||
Taxes on income |
(120 | ) | (195 | ) | (38 | %) | (387 | ) | (599 | ) | (35 | %) | ||||||||||
Income from continuing operations |
200 | 304 | (34 | %) | 623 | 922 | (32 | %) | ||||||||||||||
Loss from discontinued operations, net of tax |
| | | | (18 | ) | N/M | |||||||||||||||
Net income |
$ | 200 | $ | 304 | (34 | %) | $ | 623 | $ | 904 | (31 | %) | ||||||||||
Earnings per share from continuing operations diluted |
$ | .17 | $ | .26 | (35 | %) | $ | .54 | $ | .80 | (33 | %) | ||||||||||
Earnings per share diluted |
$ | .17 | $ | .26 | (35 | %) | $ | .54 | $ | .78 | (31 | %) | ||||||||||
Net revenue (decline) growth from prior year |
(19 | %) | (3 | %) | (17 | %) | 6 | % | ||||||||||||||
Pre-tax profit margin from continuing operations |
31.7 | % | 39.9 | % | 31.5 | % | 39.3 | % | ||||||||||||||
Return on stockholders equity (annualized) |
17 | % | 31 | % | 19 | % | 31 | % | ||||||||||||||
Annualized net revenue per average full-time equivalent employee (in thousands) |
$ | 331 | $ | 371 | (11 | %) | $ | 345 | $ | 384 | (10 | %) |
N/M | Not meaningful. |
Economic and market conditions remained challenging in the third quarter of 2009, marked by declines in home valuations, further increases in home foreclosures and delinquencies, and continued tight credit markets. At the same time, a measure of optimism returned to the equity markets as the Nasdaq Composite Index, the Standard and Poors 500 Index, and the Dow Jones Industrial Average increased 16%, 15%, and 15%, respectively, during the quarter. The equity markets were mixed when compared to the third quarter of 2008 as the Nasdaq Composite Index increased 1%, and the Standard and Poors 500 Index and the Dow Jones Industrial Average decreased 9% and 10%, respectively. In addition, the low interest rate environment continued in the third quarter as the federal funds target rate remained unchanged at a range of zero to 0.25% and the three-month LIBOR further decreased by 32 basis points to 0.30%.
During the third quarter of 2009, clients remained actively engaged with the Company. The Company attracted $19.9 billion in net new client assets during the third quarter. Total client assets ended the third quarter at $1.36 trillion, up 5% from the prior year, reflecting the Companys success in continuing to attract and retain clients. Client trading activity slowed modestly in the third quarter as clients daily average trades decreased 5% on a year-over-year basis to 318,500. This was the second highest third quarter trading activity in the Companys history surpassed only by the trading volume experienced in the third quarter of 2008.
Net revenues decreased by 19% and 17% in the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively, primarily due to the decreases in asset management and administration fees and net interest revenue. Asset management and administration fees decreased in the third quarter of 2009 primarily due to money market mutual
- 21 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
fund fee waivers of $78 million in the quarter. Asset management and administration fees decreased in the first nine months of 2009 due to lower average equity market valuations and money market mutual fund fee waivers of $114 million. There were no money market mutual fund fee waivers in 2008. Net interest revenue decreased as a result of the low interest rate environment, partially offset by higher average interest-earning assets. These decreases were partially offset by the increase in other revenue. Other revenue in the first nine months of 2009 included a $31 million gain on the repurchase of a portion of the Companys long-term debt. Other revenue in the third quarter and first nine months of 2008 included a loss of $29 million on the sale of a corporate debt security. Net revenues were also negatively impacted by net impairment charges of $11 million and $38 million in the third quarter and first nine months of 2009, respectively, relating to certain residential mortgage-backed securities available for sale. Net impairment losses on securities in the third quarter and first nine months of 2008 included an other-than-temporary impairment charge of $44 million related to a corporate debt security.
Expenses excluding interest decreased by 8% and 6% in the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively, primarily due to decreases in compensation and benefits expense, professional services expense, and advertising and market development expense. The decrease in expenses excluding interest in the first nine months of 2009 was partially offset by the increase in occupancy and equipment expense. Expenses excluding interest in the first nine months of 2009 include total facilities and severance charges of $99 million relating to the Companys cost reduction measures and a $16 million Federal Deposit Insurance Corporation (FDIC) special industry assessment that was recorded in the second quarter. Expenses excluding interest in the first nine months of 2009 were reduced by a net credit of $13 million relating to insurance recoveries of certain charges for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund investments.
As a result of the Companys cost reduction measures and ongoing expense discipline, the Company achieved a pre-tax profit margin of 31.7% and return on stockholders equity of 17% in the third quarter of 2009. Annualized net revenue per average full-time equivalent employee decreased 11% in the third quarter of 2009 compared to the same period in 2008 due to lower net revenues, partially offset by the decrease in average full-time equivalent employees.
CURRENT MARKET ENVIRONMENT
The market conditions discussed above continue to negatively impact the Companys revenues.
The Company earns mutual fund service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company. If equity valuations decline when compared to corresponding year-earlier periods, asset management and administration fees will be negatively impacted on a year-over-year basis. Additionally, mutual fund service fees may be reduced if the current interest rate environment persists. The overall yields on certain money market mutual funds have fallen to levels at or below the management fees on those funds, and the Company is waiving a portion of its fees in order to continue providing a positive return to clients. To the extent these and other money market mutual funds find it necessary to replace maturing securities with lower yielding securities on an ongoing basis, the amount of fees waived may increase.
Given the low interest rate environment, the Companys revenue from interest-earning assets, such as securities held and loans to clients, has been declining more than the rates that the Company pays on funding sources, such as customer deposits. The Companys ability to reduce those rates has been limited as short-term rates have approached zero. Continuation of the current interest rate environment will negatively impact net interest revenue.
The level at which clients utilize margin loans will also impact net interest revenue. Although the average balance of margin loans for the third quarter of 2009 increased $744 million, or 12%, from the second quarter of 2009, the average balance decreased by $4.1 billion, or 37%, from the third quarter of 2008. The average yield earned on margin loans decreased to 5.04% for the third quarter of 2009 from 5.25% for the second quarter of 2009 and from 5.68% for the third quarter of 2008. The average balance of margin loans decreased in the first nine months of 2009 by $4.9 billion, or 43%, from the first nine months of 2008 and the average yield earned on margin loans decreased to 5.26% from 5.98% for the same period.
- 22 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
The Company recorded net impairment charges of $11 million and $38 million related to certain non-agency residential mortgage-backed securities in the third quarter and first nine months of 2009, respectively, due to credit deterioration of the securities underlying collateral. Further deterioration in the performance of the underlying loans in the Companys residential mortgage-backed securities portfolio could result in the recognition of additional future impairment charges.
RESULTS OF OPERATIONS
The following discussion presents an analysis of the Companys results of operations for the third quarter and first nine months of 2009 compared to the same periods in 2008.
Net Revenues
The Companys major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. Asset management and administration fees and net interest revenue decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008. Trading revenue decreased in the third quarter and increased in the first nine months of 2009 compared to the same periods in 2008.
Three Months Ended September 30, | 2009 | 2008 | |||||||||||||||
Percent Change |
Amount | % of Total Net Revenues |
Amount | % of Total Net Revenues |
|||||||||||||
Asset management and administration fees |
|||||||||||||||||
Mutual fund service fees: |
|||||||||||||||||
Proprietary funds (Schwab Funds® and Laudus Funds®) |
(34 | %) | $ | 207 | 21 | % | $ | 312 | 25 | % | |||||||
Mutual Fund OneSource® |
(12 | %) | 126 | 12 | % | 143 | 12 | % | |||||||||
Clearing and other |
(18 | %) | 23 | 2 | % | 28 | 2 | % | |||||||||
Investment management and trust fees |
(20 | %) | 70 | 7 | % | 88 | 7 | % | |||||||||
Other |
| 25 | 3 | % | 25 | 2 | % | ||||||||||
Asset management and administration fees |
(24 | %) | 451 | 45 | % | 596 | 48 | % | |||||||||
Net interest revenue |
|||||||||||||||||
Interest revenue |
(28 | %) | 356 | 35 | % | 497 | 40 | % | |||||||||
Interest expense |
24 | % | (62 | ) | (6 | %) | (50 | ) | (4 | %) | |||||||
Net interest revenue |
(34 | %) | 294 | 29 | % | 447 | 36 | % | |||||||||
Trading revenue |
|||||||||||||||||
Commissions |
(2 | %) | 217 | 21 | % | 222 | 18 | % | |||||||||
Principal transactions |
(20 | %) | 24 | 3 | % | 30 | 2 | % | |||||||||
Trading revenue |
(4 | %) | 241 | 24 | % | 252 | 20 | % | |||||||||
Other |
N/M | 36 | 3 | % | | | |||||||||||
Net impairment losses on securities |
(75 | %) | (11 | ) | (1 | %) | (44 | ) | (4 | %) | |||||||
Total net revenues |
(19 | %) | $ | 1,011 | 100 | % | $ | 1,251 | 100 | % | |||||||
N/M Not meaningful.
- 23 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Nine Months Ended September 30, | 2009 | 2008 | |||||||||||||||
Percent Change |
Amount | % of Total Net Revenues |
Amount | % of Total Net Revenues |
|||||||||||||
Asset management and administration fees |
|||||||||||||||||
Mutual fund service fees: |
|||||||||||||||||
Proprietary funds (Schwab Funds® and Laudus Funds®) |
(18 | %) | $ | 780 | 24 | % | $ | 949 | 25 | % | |||||||
Mutual Fund OneSource® |
(28 | %) | 321 | 10 | % | 446 | 12 | % | |||||||||
Clearing and other |
(23 | %) | 66 | 2 | % | 86 | 2 | % | |||||||||
Investment management and trust fees |
(27 | %) | 199 | 6 | % | 271 | 7 | % | |||||||||
Other |
(3 | %) | 73 | 3 | % | 75 | 1 | % | |||||||||
Asset management and administration fees |
(21 | %) | 1,439 | 45 | % | 1,827 | 47 | % | |||||||||
Net interest revenue |
|||||||||||||||||
Interest revenue |
(28 | %) | 1,063 | 33 | % | 1,485 | 38 | % | |||||||||
Interest expense |
(16 | %) | (161 | ) | (5 | %) | (192 | ) | (5 | %) | |||||||
Net interest revenue |
(30 | %) | 902 | 28 | % | 1,293 | 33 | % | |||||||||
Trading revenue |
|||||||||||||||||
Commissions |
7 | % | 679 | 21 | % | 634 | 17 | % | |||||||||
Principal transactions |
(1 | %) | 93 | 3 | % | 94 | 2 | % | |||||||||
Trading revenue |
6 | % | 772 | 24 | % | 728 | 19 | % | |||||||||
Other |
113 | % | 132 | 4 | % | 62 | 2 | % | |||||||||
Net impairment losses on securities |
(14 | %) | (38 | ) | (1 | %) | (44 | ) | (1 | %) | |||||||
Total net revenues |
(17 | %) | $ | 3,207 | 100 | % | $ | 3,866 | 100 | % | |||||||
Asset Management and Administration Fees
Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for shareholder services, administration, and investment management provided to its proprietary funds, recordkeeping and shareholder services provided to third-party funds, and transfer agent services (through July 2009). These fees are based upon the daily balances of client assets invested in third-party funds and the Companys proprietary funds. The Company also earns asset management fees for advisory and managed account services, which are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets, which include proprietary and third-party mutual funds, are based on quoted market prices and other observable market data. Asset management and administration fees may vary with changes in the balances of client assets due to market fluctuations and client activity. For discussion of the impact of current market conditions on asset management and administration fees, see Current Market Environment.
Asset management and administration fees decreased by $145 million, or 24%, and $388 million, or 21%, in the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively, primarily due to decreases in mutual fund service fees and investment management and trust fees, which resulted from money market mutual fund fee waivers and lower average equity market valuations of client assets.
Mutual fund service fees decreased by $127 million, or 26%, and $314 million, or 21%, in the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively. Given the low interest rate environment in the third quarter and first nine months of 2009, the overall yields on certain of the Companys money market mutual funds have fallen to levels at or below the management fees on those funds. As a result, the Company waived a portion of its fees which totaled $78 million and $114 million in the third quarter and first nine months of 2009, respectively, in order to provide a positive return to clients. The decrease in the third quarter of 2009 was also due to a 7% decrease in the average balances of client assets invested in the Companys proprietary funds. The decrease in the first nine months of 2009 was also due to
- 24 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
decreases of 18% and 21% in the average balances of client assets invested in the Companys Mutual Fund OneSource funds and mutual fund clearing services, respectively.
Investment management and trust fees decreased by $18 million, or 20%, and $72 million, or 27%, in the third quarter and first nine months of 2009 compared to the same periods in 2008, respectively, primarily due to temporary fee waivers of $21 million and $39 million, respectively, relating to client asset balances participating in advisory and managed account services programs. The decrease in the first nine months of 2009 was also due to lower average client asset balances in these programs.
Net Interest Revenue
Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and portfolio management strategies. The Company is positioned so that the consolidated balance sheet produces an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall (i.e., interest-earning assets generally reprice more quickly than interest-bearing liabilities). When interest rates fall, the Company attempts to mitigate some of this negative impact by extending the maturities of assets in investment portfolios to lock-in asset yields as well as by lowering rates paid to clients on interest-bearing liabilities. Since the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, as well as the rates charged on receivables from brokerage clients, and also controls the composition of its investment securities, it has some ability to manage its net interest spread. However, the spread is influenced by external factors such as the interest rate environment and competition. For discussion of the impact of current market conditions on net interest revenue, see Current Market Environment.
In clearing its clients trades, Charles Schwab & Co., Inc. (Schwab) holds cash balances payable to clients. In most cases, Schwab pays its clients interest on cash balances awaiting investment, and may invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made by Schwab to clients on a secured basis to purchase securities. Pursuant to Securities and Exchange Commission (SEC) regulations, client cash balances that are not used for margin lending are generally segregated into investment accounts that are maintained for the exclusive benefit of clients which are recorded in cash and investments segregated on the Companys condensed consolidated balance sheet.
The Companys interest-earning assets are financed primarily by brokerage client cash balances and deposits from banking clients. Other funding sources include non-interest-bearing brokerage client cash balances and proceeds from stock-lending activities, as well as stockholders equity.
- 25 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
The following tables present net interest revenue information corresponding to interest-earning assets and funding sources on the condensed consolidated balance sheet:
Three Months Ended September 30, | 2009 | 2008 | ||||||||||||||||
Average Balance |
Interest Revenue/ Expense |
Average Yield/ Rate |
Average Balance |
Interest Revenue/ Expense |
Average Yield/ Rate |
|||||||||||||
Interest-earning assets: |
||||||||||||||||||
Cash and cash equivalents |
$ | 9,366 | $ | 7 | 0.30 | % | $ | 4,333 | $ | 27 | 2.48 | % | ||||||
Cash and investments segregated |
16,584 | 16 | 0.38 | % | 10,506 | 64 | 2.42 | % | ||||||||||
Broker-related receivables (1) |
383 | | 0.14 | % | 435 | 2 | 1.83 | % | ||||||||||
Receivables from brokerage clients |
7,006 | 89 | 5.04 | % | 11,133 | 159 | 5.68 | % | ||||||||||
Other securities owned (2) |
158 | | 0.87 | % | | | | |||||||||||
Securities available for sale (3) |
18,942 | 127 | 2.66 | % | 13,493 | 145 | 4.28 | % | ||||||||||
Securities held to maturity |
2,874 | 28 | 3.87 | % | | | | |||||||||||
Loans to banking clients |
6,795 | 61 | 3.56 | % | 5,232 | 62 | 4.71 | % | ||||||||||
Loans held for sale |
69 | 1 | 5.75 | % | 51 | 1 | 7.80 | % | ||||||||||
Total interest-earning assets |
62,177 | 329 | 2.10 | % | 45,183 | 460 | 4.05 | % | ||||||||||
Other interest revenue |
27 | 37 | ||||||||||||||||
Total interest-earning assets |
$ | 62,177 | $ | 356 | 2.27 | % | $ | 45,183 | $ | 497 | 4.38 | % | ||||||
Funding sources: |
||||||||||||||||||
Deposits from banking clients |
$ | 33,792 | $ | 32 | 0.38 | % | $ | 20,416 | $ | 22 | 0.43 | % | ||||||
Payables to brokerage clients (2) |
18,474 | | 0.01 | % | 15,084 | 6 | 0.16 | % | ||||||||||
Short-term borrowings (4) |
| | | 47 | | 2.27 | % | |||||||||||
Long-term debt |
1,535 | 22 | 5.69 | % | 882 | 14 | 6.31 | % | ||||||||||
Total interest-bearing liabilities |
53,801 | 54 | 0.40 | % | 36,429 | 42 | 0.46 | % | ||||||||||
Non-interest-bearing funding sources |
8,376 | 8,754 | ||||||||||||||||
Provision for credit losses |
7 | 5 | ||||||||||||||||
Other interest expense |
1 | 3 | ||||||||||||||||
Total funding sources |
$ | 62,177 | $ | 62 | 0.39 | % | $ | 45,183 | $ | 50 | 0.44 | % | ||||||
Net interest revenue |
$ | 294 | 1.88 | % | $ | 447 | 3.94 | % | ||||||||||
(1) | Includes receivables from brokers, dealers, and clearing organizations. Interest revenue on broker-related receivables was less than $500,000 in the third quarter of 2009. |
(2) | Interest revenue on other securities owned and interest expense on payables to brokerage clients was less than $500,000 in the third quarter of 2009. |
(3) | Amounts have been calculated based on amortized cost. |
(4) | Interest expense on short-term borrowings was less than $500,000 in the third quarter of 2008. |
- 26 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Nine Months Ended September 30, | 2009 | 2008 | ||||||||||||||||
Average Balance |
Interest Revenue/ Expense |
Average Yield/ Rate |
Average Balance |
Interest Revenue/ Expense |
Average Yield/ Rate |
|||||||||||||
Interest-earning assets: |
||||||||||||||||||
Cash and cash equivalents |
$ | 7,795 | $ | 27 | 0.46 | % | $ | 4,808 | $ | 108 | 3.00 | % | ||||||
Cash and investments segregated |
15,815 | 67 | 0.57 | % | 10,350 | 231 | 2.98 | % | ||||||||||
Broker-related receivables |
355 | 1 | 0.38 | % | 501 | 8 | 2.13 | % | ||||||||||
Receivables from brokerage clients |
6,457 | 254 | 5.26 | % | 11,348 | 508 | 5.98 | % | ||||||||||
Other securities owned (1) |
53 | | 0.88 | % | | | | |||||||||||
Securities available for sale (2) |
17,235 | 389 | 3.02 | % | 10,865 | 360 | 4.43 | % | ||||||||||
Securities held to maturity |
1,443 | 43 | 3.98 | % | | | | |||||||||||
Loans to banking clients |
6,497 | 177 | 3.64 | % | 4,491 | 164 | 4.88 | % | ||||||||||
Loans held for sale |
121 | 5 | 5.52 | % | 73 | 3 | 5.49 | % | ||||||||||
Total interest-earning assets |
55,771 | 963 | 2.31 | % | 42,436 | 1,382 | 4.35 | % | ||||||||||
Other interest revenue |
100 | 103 | ||||||||||||||||
Total interest-earning assets |
$ | 55,771 | $ | 1,063 | 2.55 | % | $ | 42,436 | $ | 1,485 | 4.67 | % | ||||||
Funding sources: |
||||||||||||||||||
Deposits from banking clients |
$ | 29,285 | $ | 73 | 0.33 | % | $ | 17,862 | $ | 79 | 0.59 | % | ||||||
Payables to brokerage clients |
17,393 | 2 | 0.02 | % | 15,144 | 49 | 0.43 | % | ||||||||||
Short-term borrowings |
| | | 47 | 1 | 2.20 | % | |||||||||||
Long-term debt |
1,134 | 51 | 6.01 | % | 892 | 44 | 6.59 | % | ||||||||||
Total interest-bearing liabilities |
47,812 | 126 | 0.35 | % | 33,945 | 173 | 0.68 | % | ||||||||||
Non-interest-bearing funding sources |
7,959 | 8,491 | ||||||||||||||||
Provision for credit losses |
33 | 11 | ||||||||||||||||
Other interest expense |
2 | 8 | ||||||||||||||||
Total funding sources |
$ | 55,771 | $ | 161 | 0.39 | % | $ | 42,436 | $ | 192 | 0.60 | % | ||||||
Net interest revenue |
$ | 902 | 2.16 | % | $ | 1,293 | 4.07 | % | ||||||||||
(1) | Interest revenue on other securities owned was less than $500,000 in the first nine months of 2009. |
(2) | Amounts have been calculated based on amortized cost. |
Net interest revenue decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008, due to the low interest rate environment that persisted in the third quarter and first nine months of 2009. As a result, the Company experienced declines in the yields and rates of almost all interest-earning assets and interest-bearing liabilities compared to the third quarter and first nine months of 2008. The mix of interest-earning assets also negatively affected net interest revenue most notably the decrease in average margin loans resulted in higher average balances of cash and investments segregated, a lower yielding asset category. The effect of the low interest rate environment and asset mix was partially offset by the growth in average balances. The Company experienced significant growth in deposits from banking clients, which in turn funded increases in the average balances of securities available for sale, loans to banking clients, and cash and cash equivalents.
Trading Revenue
Trading revenue includes commission and principal transaction revenues. Commission revenues are affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenues are primarily comprised of revenues from client fixed income securities trading activity. Factors that influence principal transaction revenues include the volume of client trades, market price volatility, and competitive pressures.
Trading revenue decreased by $11 million, or 4%, in the third quarter of 2009 compared to the third quarter of 2008 due to lower daily average revenue trades and lower average revenue earned per revenue trade, offset by lower investment losses.
- 27 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Trading revenue increased by $44 million, or 6%, in the first nine months of 2009 compared to the first nine months of 2008 due to higher daily average revenue trades and investment gains, offset by lower average revenue earned per revenue trade.
As shown in the following table, daily average revenue trades decreased 3% in the third quarter of 2009 primarily due to lower volumes of principal transaction and equity trades. Daily average revenue trades increased 8% in the first nine months of 2009 due to higher volumes of equity and mutual fund trades, offset by lower volumes of principal transaction and option trades. Average revenue earned per revenue trade decreased 5% in the third quarter of 2009 primarily due to lower average revenue earned per revenue trade for mutual funds and principal transactions, offset by higher average revenue earned per revenue trade for options. Average revenue earned per revenue trade decreased 4% in the first nine months of 2009 primarily due to lower average revenue earned per revenue trade for principal transactions and mutual funds, offset by higher average revenue earned per revenue trade for equity securities.
Three Months Ended September 30, |
Percent Change |
Nine Months Ended September 30, |
Percent Change |
|||||||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||||||||
Daily average revenue trades (in thousands) (1) |
273.7 | 282.9 | (3 | %) | 292.4 | 270.7 | 8 | % | ||||||||||||||
Number of trading days |
64.0 | 63.5 | 1 | % | 188.0 | 188.5 | | |||||||||||||||
Average revenue earned per revenue trade |
$ | 13.93 | $ | 14.59 | (5 | %) | $ | 13.94 | $ | 14.48 | (4 | %) |
(1) | Includes all client trades that generate trading revenue (i.e., commission revenue or revenue from fixed income securities trading). |
Other Revenue
Other revenue includes gains on the repurchases of long-term debt, realized gains and losses on sales of securities available for sale, gains and losses on sales of loans held for sale, service fees, and software maintenance fees. Other revenue increased by $70 million, or 113%, in the first nine months of 2009 from the first nine months of 2008 primarily due to the recognition of a gain on the repurchase of a portion of the Companys long-term debt. The Company repurchased $98 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $67 million in the first nine months of 2009. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $31 million. Other revenue in the third quarter and first nine months of 2008 included a realized loss of $29 million on the sale of corporate debt securities issued by Washington Mutual Bank as a result of its seizure by the FDIC in September 2008.
Net Impairment Losses on Securities
The Company recorded net impairment charges of $11 million and $38 million related to certain non-agency residential mortgage-backed securities in the third quarter and first nine months of 2009, respectively, due to credit deterioration of the securities underlying collateral. In the third quarter and first nine months of 2008, the Company recognized an other-than-temporary impairment charge of $44 million on corporate debt securities issued by Lehman Brothers Holdings, Inc. (Lehman) as a result of Lehmans Chapter 11 bankruptcy petition filing in September 2008. The Company sold these securities in October 2008. See note 3 Securities Available for Sale and Securities Held to Maturity for further discussion.
- 28 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Expenses Excluding Interest
As shown in the table below, expenses excluding interest decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008, primarily due to decreases in compensation and benefits expense, professional services expense, and advertising and market development expense. The decrease in the first nine months of 2009 was partially offset by the increase in occupancy and equipment expense.
Three Months Ended September 30, |
Percent Change |
Nine Months Ended September 30, |
Percent Change |
|||||||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||||||||
Compensation and benefits |
$ | 371 | $ | 390 | (5 | %) | $ | 1,173 | $ | 1,265 | (7 | %) | ||||||||||
Professional services |
70 | 86 | (19 | %) | 194 | 254 | (24 | %) | ||||||||||||||
Occupancy and equipment |
67 | 75 | (11 | %) | 245 | 221 | 11 | % | ||||||||||||||
Advertising and market development |
34 | 47 | (28 | %) | 141 | 181 | (22 | %) | ||||||||||||||
Communications |
48 | 51 | (6 | %) | 155 | 155 | | |||||||||||||||
Depreciation and amortization |
38 | 38 | | 121 | 113 | 7 | % | |||||||||||||||
Other |
63 | 65 | (3 | %) | 168 | 156 | 8 | % | ||||||||||||||
Total expenses excluding interest |
$ | 691 | $ | 752 | (8 | %) | $ | 2,197 | $ | 2,345 | (6 | %) | ||||||||||
Expenses as a percentage of total net revenues: |
||||||||||||||||||||||
Total expenses excluding interest |
68 | % | 60 | % | 69 | % | 61 | % | ||||||||||||||
Advertising and market development |
3 | % | 4 | % | 4 | % | 5 | % |
Compensation and Benefits
Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation is based on the achievement of specified performance objectives, including revenue growth and profit margin, and therefore will fluctuate with these measures.
- 29 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Compensation and benefits expense decreased by $19 million, or 5%, in the third quarter of 2009 compared to the third quarter of 2008 primarily due to a decrease in salaries and wages expense. Compensation and benefits expense decreased $92 million, or 7%, in the first nine months of 2009 compared to the first nine months of 2008 primarily due to decreases in incentive compensation and salaries and wages expense. The following table shows a comparison of certain compensation and benefits components and employee data:
Three Months Ended September 30, |
Percent Change |
Nine Months Ended September 30, |
Percent Change |
|||||||||||||||||||
2009 | 2008 | 2009 | 2008 | |||||||||||||||||||
Salaries and wages |
$ | 214 | $ | 248 | (14 | %) | $ | 713 | $ | 753 | (5 | %) | ||||||||||
Incentive compensation (1) |
91 | 83 | 10 | % | 261 | 316 | (17 | %) | ||||||||||||||
Employee benefits and other |
66 | 59 | 12 | % | 199 | 196 | 2 | % | ||||||||||||||
Total compensation and benefits expense |
$ | 371 | $ | 390 | (5 | %) | $ | 1,173 | $ | 1,265 | (7 | %) | ||||||||||
Compensation and benefits expense as a percentage of total net revenues: |
||||||||||||||||||||||
Salaries and wages |
21 | % | 20 | % | 22 | % | 20 | % | ||||||||||||||
Incentive compensation |
9 | % | 7 | % | 8 | % | 8 | % | ||||||||||||||
Employee benefits and other |
7 | % | 4 | % | 7 | % | 5 | % | ||||||||||||||
Total compensation and benefits expense |
37 | % | 31 | % | 37 | % | 33 | % | ||||||||||||||
Full-time equivalent employees (in thousands) (2) |
||||||||||||||||||||||
At quarter end |
12.2 | 13.5 | (10 | %) | ||||||||||||||||||
Average |
12.2 | 13.5 | (10 | %) | 12.4 | 13.4 | (7 | %) |
(1) | Includes variable compensation, discretionary bonus costs, stock-based compensation, and employee stock purchase plan expense. |
(2) | Includes full-time, part-time and temporary employees, and persons employed on a contract basis, and excludes employees of outsourced service providers. |
Salaries and wages decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008 primarily due to lower expense as a result of decreases in full-time employees and persons employed on a contract basis. The decrease in salaries and wages in the first nine months of 2009 was offset by severance expense of $56 million relating to the Companys cost reduction measures.
Incentive compensation decreased in the first nine months of 2009 compared to the first nine months of 2008 primarily due to lower variable compensation based on actual performance in the first nine months of 2009. In addition, incentive compensation in the first nine months of 2008 included long-term incentive plan compensation. The last performance period under the Companys long-term incentive program ended on December 31, 2008.
Expenses Excluding Compensation and Benefits
Professional services expense decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008 primarily due to a decrease in fees paid to outsourced service providers and consultants.
Occupancy and equipment expense increased in the first nine months of 2009 compared to the first nine months of 2008 primarily due to facilities charges of $43 million relating to the Companys cost reduction measures, partially offset by lower purchases of equipment.
Advertising and market development expense decreased in the third quarter and first nine months of 2009 compared to the same periods in 2008 primarily due to lower media spending relating to the Companys Talk to ChuckTM national advertising campaign. Media spending decreased by $10 million and $27 million and marketing expense decreased by $3 million and $13 million in the third quarter and first nine months of 2009, respectively.
- 30 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Other expense increased in the first nine months of 2009 compared to the first nine months of 2008 primarily due to a $16 million FDIC special industry assessment recorded in the second quarter and higher FDIC insurance premiums caused by higher deposits from banking clients, partially offset by a decrease in employee travel expenses. Other expense in the first nine months of 2009 also included charges of $21 million for individual client complaints and arbitration claims relating to Schwab YieldPlus Fund® investments (YieldPlus Expenses), offset by $34 million of insurance recoveries, resulting in a net credit of $13 million. YieldPlus Expenses and insurance recoveries in the third quarter of 2009 were not material. Other expense in the first nine months of 2008 included YieldPlus Expenses of $24 million.
Taxes on Income
The Companys effective income tax rate on income from continuing operations before taxes was 37.5% and 39.1% for the third quarters of 2009 and 2008, respectively. The Companys effective income tax rate on income from continuing operations before taxes was 38.3% and 39.4% for the first nine months of 2009 and 2008, respectively. The decrease in the third quarter and first nine months of 2009 was primarily due to lower effective state income tax rates.
Segment Information
The Company provides financial services to individuals and institutional clients through two segments Investor Services and Institutional Services. As a result of organizational and related business changes in the first quarter of 2009, the segments formerly reported as Advisor Services and Corporate and Retirement Services were combined into a single segment called Institutional Services. Previously reported segment information has been revised to reflect this change. The Investor Services segment includes the Companys retail brokerage and banking operations. The Institutional Services segment provides custodial, trading, and support services to independent investment advisors, as well as retirement plan services, plan administrator services, stock plan services, and mutual fund clearing services. In addition, the Institutional Services segment supports the availability of Schwab proprietary mutual funds on third-party platforms. The Company evaluates the performance of its segments on a pre-tax basis excluding items such as impairment charges on non-financial assets, discontinued operations, extraordinary items, and other significant restructuring charges.
Financial information for the Companys reportable segments is presented in the following table:
Three Months Ended September 30, |
Percent Change |
Nine Months Ended September 30, |
Percent Change |
||||||||||||||||||
2009 | 2008 | 2009 | 2008 | ||||||||||||||||||
Investor Services: |
|||||||||||||||||||||
Net revenues |
$ | 658 | $ | 820 | (20 | %) | $ | 2,069 | $ | 2,557 | (19 | %) | |||||||||
Expenses excluding interest |
462 | 505 | (9 | %) | 1,415 | 1,588 | (11 | %) | |||||||||||||
Contribution margin |
$ | 196 | $ | 315 | (38 | %) | $ | 654 | $ | 969 | (33 | %) | |||||||||
Institutional Services: |
|||||||||||||||||||||
Net revenues |
$ | 353 | $ | 428 | (18 | %) | $ | 1,138 | $ | 1,299 | (12 | %) | |||||||||
Expenses excluding interest |
228 | 243 | (6 | %) | 695 | 747 | (7 | %) | |||||||||||||
Contribution margin |
$ | 125 | $ | 185 | (32 | %) | $ | 443 | $ | 552 | (20 | %) | |||||||||
Unallocated: |
|||||||||||||||||||||
Net revenues |
$ | | $ | 3 | N/M | $ | | $ | 10 | N/M | |||||||||||
Expenses excluding interest |
1 | 4 | N/M | 87 | 10 | N/M | |||||||||||||||
Contribution margin |
$ | (1 | ) | $ | (1 | ) | N/M | $ | (87 | ) | $ | | N/M | ||||||||
Total: |
|||||||||||||||||||||
Net revenues |
$ | 1,011 | $ | 1,251 | (19 | %) | $ | 3,207 | $ | 3,866 | (17 | %) | |||||||||
Expenses excluding interest |
691 | 752 | (8 | %) | 2,197 | 2,345 | (6 | %) | |||||||||||||
Contribution margin |
$ | 320 | $ | 499 | (36 | %) | $ | 1,010 | $ | 1,521 | (34 | %) | |||||||||
N/M Not meaningful.
- 31 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Investor Services
Net revenues decreased by $162 million, or 20%, in the third quarter of 2009 compared to the third quarter of 2008 primarily due to decreases in asset management and administration fees and net interest revenue, offset by an increase in other revenue and lower net impairment losses on securities. Asset management and administration fees decreased primarily due to money market mutual fund fee waivers. Net interest revenue decreased as a result of the low interest rate environment, partially offset by higher average interest-earning assets. Other revenue and net impairment losses on securities in the prior year included a loss on the sale and an other-than-temporary impairment charge, respectively, related to two corporate debt securities in the third quarter of 2008. Expenses excluding interest decreased by $43 million, or 9%, in the third quarter of 2009 compared to the third quarter of 2008 primarily due to lower professional services, advertising and market development, and other expenses.
Net revenues decreased by $488 million, or 19%, in the first nine months of 2009 compared to the first nine months of 2008 primarily due to decreases in asset management and administration fees, net interest revenue, and other revenue, partially offset by an increase in trading revenue. Asset management and administration fees decreased due to lower average equity market valuations and money market mutual fund fee waivers. Net interest revenue decreased as a result of the low interest rate environment, partially offset by higher average interest-earning assets. Trading revenue increased due to higher daily average revenue trades. Other revenue increased primarily due to a gain on the repurchase of a portion of the Companys long-term debt in the first nine months of 2009. The increase in other revenue is also attributed to the loss on the sale of a corporate debt security in the third quarter of 2008 discussed above. Expenses excluding interest decreased by $173 million, or 11%, in the first nine months of 2009 compared to the first nine months of 2008 primarily due to lower compensation and benefits, professional services, and other expenses.
Institutional Services
Net revenues decreased by $75 million, or 18%, in the third quarter of 2009 compared to the third quarter of 2008 due to decreases in asset management and administration fees and net interest revenue, offset by an increase in other revenue and lower net impairment losses on securities. Asset management and administration fees decreased primarily due to money market mutual fund fee waivers. Net interest revenue decreased as a result of the low interest rate environment, partially offset by higher average interest-earning assets. Other revenue and net impairment losses on securities in the prior year included a loss on the sale and an other-than-temporary impairment charge, respectively, related to two corporate debt securities in the third quarter of 2008. Expenses excluding interest decreased by $15 million, or 6%, in the third quarter of 2009 compared to the third quarter of 2008 primarily due to lower compensation and benefits and professional services expenses.
Net revenues decreased by $161 million, or 12%, in the first nine months of 2009 compared to the first nine months of 2008, due to decreases in asset management and administration fees and net interest revenue, offset by increases in trading revenue and other revenue. Asset management and administration fees decreased due to lower average equity market valuations and money market mutual fund fee waivers. Net interest revenue decreased as a result of the low interest rate environment, partially offset by higher average interest-earning assets. Trading revenue increased due to higher daily average revenue trades. Other revenue increased primarily due to a gain on the repurchase of a portion of the Companys long-term debt in the first nine months of 2009. The increase in other revenue is also attributed to the loss on the sale of a corporate debt security in the third quarter of 2008 discussed above. Expenses excluding interest decreased by $52 million, or 7%, in the first nine months of 2009 compared to the first nine months of 2008 primarily due to lower compensation and benefits and professional services expenses, partially offset by other expense.
Unallocated
Expenses excluding interest in the first nine months of 2009 include facilities and severance charges relating to the Companys cost reduction measures.
- 32 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
LIQUIDITY AND CAPITAL RESOURCES
CSC conducts substantially all of its business through its wholly-owned subsidiaries. The capital structure among CSC and its subsidiaries is designed to provide each entity with capital and liquidity to meet its operational needs and regulatory requirements.
CSC is a savings and loan holding company and Schwab Bank, CSCs depository institution, is a federal savings bank. CSC and Schwab Bank are both subject to supervision and regulation by the Office of Thrift Supervision.
Liquidity
CSC
As a savings and loan holding company, CSC is not subject to specific statutory capital requirements. However, CSC is required to maintain capital that is sufficient to support the holding company and its subsidiaries business activities, and the risks inherent in those activities. To manage capital adequacy, CSC currently utilizes a target Tier 1 Leverage Ratio, as defined by the Board of Governors of the Federal Reserve System, of at least 6%. At September 30, 2009, CSCs Tier 1 Leverage Ratio was 7.4%.
CSCs liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. CSC maintains excess liquidity in the form of overnight cash deposits and short-term investments to cover daily funding needs and to support growth in the Companys business. Generally, CSC does not hold liquidity at its subsidiaries in excess of amounts deemed sufficient to support the subsidiaries operations, including any regulatory capital requirements. Schwab and Schwab Bank are subject to regulatory requirements that may restrict them from certain transactions with CSC. Management believes that funds generated by the operations of CSCs subsidiaries will continue to be the primary funding source in meeting CSCs liquidity needs, providing adequate liquidity to meet Schwab Banks capital guidelines, and maintaining Schwabs net capital.
CSC has liquidity needs that arise from its Senior Medium-Term Notes, Series A (Medium-Term Notes), Junior Subordinated Notes, and Senior Notes, as well as from the funding of cash dividends, acquisitions, and other investments. The Medium-Term Notes, of which $450 million was outstanding at September 30, 2009, have maturities ranging from 2010 to 2017 and fixed interest rates ranging from 6.375% to 8.05% with interest payable semiannually. The Medium-Term Notes are rated A2 by Moodys Investors Service (Moodys), A by Standard & Poors Ratings Group (S&P), and A by Fitch Ratings, Ltd. (Fitch). At September 30, 2009, $202 million of Junior Subordinated Notes were outstanding and have a fixed interest rate of 7.50% until 2017 and a floating rate thereafter. The Junior Subordinated Notes are not rated, however the trust preferred securities related to these notes are rated A3 by Moodys, BBB+ by S&P, and A- by Fitch. In the first nine months of 2009, CSC repurchased $98 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $67 million. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $31 million.
CSC has a universal automatic shelf registration statement on file with the SEC which enables CSC to issue debt, equity and other securities. In June 2009, the Company issued $750 million of Senior Notes that mature in 2014 under this registration statement. The Senior Notes have a fixed interest rate of 4.950% with interest payable semiannually. The Senior Notes are rated A2 by Moodys, A by S&P, and A by Fitch.
CSC has authorization from its Board of Directors to issue unsecured commercial paper notes (Commercial Paper Notes) not to exceed $1.5 billion. Management has set a current limit for the commercial paper program of $800 million. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. The commercial paper is not redeemable prior to maturity and is not subject to voluntary prepayment. The proceeds of the commercial paper program are to be used for general corporate purposes. There were no Commercial Paper Notes outstanding at September 30, 2009. CSCs ratings for these short-term borrowings are P-1 by Moodys, A-1 by S&P, and F1 by Fitch.
CSC maintains an $800 million committed, unsecured credit facility with a group of 12 banks which is scheduled to expire in June 2010. This facility replaced a similar facility that expired in June 2009. These facilities were unused during the first
- 33 -
THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
nine months of 2009. The funds under this facility are available for general corporate purposes, including repayment of the Commercial Paper Notes discussed above. If any Commercial Paper Notes are outstanding, the amount of this facility that CSC could use for other general corporate purposes will be reduced. The financial covenants under this facility require Schwab to maintain a minimum net capital ratio, as defined, Schwab Bank to be well capitalized, as defined, and CSC to maintain a minimum level of stockholders equity. At September 30, 2009, the minimum level of stockholders equity required under this facility was $3.2 billion. Management believes that these restrictions will not have a material effect on CSCs ability to meet foreseeable dividend or funding requirements.
CSC also has direct access to $745 million of the $822 million uncommitted, unsecured bank credit lines discussed below, that are primarily utilized by Schwab to manage short-term liquidity. These lines were not used by CSC during the first nine months of 2009.
In addition, Schwab provides CSC with a $1.0 billion credit facility maturing in December 2009. No funds were drawn under this facility at September 30, 2009.
Schwab
Schwab is subject to regulatory requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings to CSC, paying cash dividends, or making unsecured advances or loans to its parent or employees if such payment would result in net capital of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement of $250,000. At September 30, 2009, Schwabs net capital was $1.1 billion (12% of aggregate debit balances), which was $897 million in excess of its minimum required net capital and $624 million in excess of 5% of aggregate debit balances.
Most of Schwabs assets are readily convertible to cash, consisting primarily of short-term (i.e., less than 150 days) investment-grade, interest-earning investments (the majority of which are segregated for the exclusive benefit of clients pursuant to regulatory requirements), receivables from brokerage clients, and receivables from brokers, dealers, and clearing organizations. Client margin loans are demand loan obligations secured by readily marketable securities. Receivables from and payables to brokers, dealers, and clearing organizations primarily represent current open transactions, which usually settle, or can be closed out, within a few business days.
Liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $22.8 billion and $19.2 billion at September 30, 2009 and December 31, 2008, respectively. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab in the future.
Schwab has a finance lease obligation related to an office building and land under a 20-year lease. The remaining finance lease obligation of $113 million at September 30, 2009, is being reduced by a portion of the lease payments over the remaining lease term of approximately 15 years.
To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines with a group of seven banks totaling $822 million at September 30, 2009. The need for short-term borrowings arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, and movements of cash to meet segregation requirements. Schwab used such borrowings for four days during the first nine months of 2009, with daily amounts borrowed averaging $31 million. There were no borrowings outstanding under these lines at September 30, 2009.
To satisfy the margin requirement of client option transactions with the Options Clearing Corporation (OCC), Schwab has unsecured standby letter of credit agreements (LOCs) with seven banks in favor of the OCC aggregating $445 million at September 30, 2009. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by arranging LOCs, in favor of these brokerage clients, which are issued by multiple banks. At September 30, 2009, the aggregate face amount of these LOCs totaled $31 million. There were no funds drawn under any of these LOCs during the first nine months of 2009.
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THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
To manage Schwabs regulatory capital requirement, CSC provides Schwab with a $1.4 billion subordinated revolving credit facility which is scheduled to expire in March 2010. The amount outstanding under this facility at September 30, 2009, was $220 million. Borrowings under this subordinated lending arrangement qualify as regulatory capital for Schwab.
In addition, CSC provides Schwab with a $1.5 billion credit facility which is scheduled to expire in 2011. Borrowings under this facility do not qualify as regulatory capital for Schwab. There were no funds drawn under this facility at September 30, 2009.
Schwab Bank
Schwab Bank is required to maintain a capital level that at least equals minimum capital levels specified in federal banking laws and regulations. Failure to meet the minimum levels will result in certain mandatory, and possibly additional discretionary, actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. Based on its regulatory capital ratios at September 30, 2009, Schwab Bank is considered well capitalized. Schwab Banks regulatory capital and ratios at September 30, 2009, are as follows:
Actual | Minimum Capital Requirement |
Minimum to be Well Capitalized |
||||||||||||||||
Amount | Ratio | Amount | Ratio | Amount | Ratio | |||||||||||||
Tier 1 Capital |
$ | 2,454 | 17.0 | % | $ | 578 | 4.0 | % | $ | 868 | 6.0 | % | ||||||
Total Capital |
$ | 2,498 | 17.3 | % | $ | 1,157 | 8.0 | % | $ | 1,446 | 10.0 | % | ||||||
Leverage |
$ | 2,454 | 6.4 | % | $ | 1,538 | 4.0 | % | $ | 1,922 | 5.0 | % | ||||||
Tangible Equity |
$ | 2,454 | 6.4 | % | $ | 769 | 2.0 | % | N/A |
N/A Not applicable.
Schwab Banks current liquidity needs are generally met through deposits from banking clients and equity capital.
The excess cash held in certain Schwab brokerage client accounts is swept into deposit accounts at Schwab Bank. At September 30, 2009, these balances totaled $21.8 billion.
Schwab Bank has access to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements. Additionally, Schwab Bank has access to short-term funding through the Federal Reserve Bank (FRB) discount window. Amounts available under the FRB discount window are dependent on the fair value of certain of Schwab Banks securities available for sale and securities held to maturity that are pledged as collateral. At September 30, 2009, $1.1 billion was available under this arrangement. There were no funds drawn under this arrangement during the first nine months of 2009.
Schwab Bank maintains a credit facility with the Federal Home Loan Bank System (FHLB). Amounts available under this facility are dependent on the amount of Schwab Banks residential real estate mortgages and home equity lines of credit that are pledged as collateral. At September 30, 2009, $2.4 billion was available under this facility. There were no funds drawn under this facility during the first nine months of 2009.
CSC provides Schwab Bank with a $100 million short-term credit facility which is scheduled to expire in December 2009. Borrowings under this facility do not qualify as regulatory capital for Schwab Bank. There were no funds drawn under this facility during the first nine months of 2009.
Capital Resources
The Company monitors both the relative composition and absolute level of its capital structure. Management is focused on limiting the Companys use of capital and currently targets a long-term debt to total financial capital ratio not to exceed 30%. The Companys total financial capital (long-term debt plus stockholders equity) at September 30, 2009, was $6.4 billion, up $1.5 billion, or 30%, from December 31, 2008.
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THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
At September 30, 2009, the Company had long-term debt of $1.5 billion, or 24% of total financial capital, that bears interest at a weighted-average rate of 5.97%. At December 31, 2008, the Company had long-term debt of $883 million, or 18% of total financial capital. In June 2009, the Company issued $750 million of Senior Notes that mature in 2014 and have a fixed interest rate of 4.950%. The Company repaid $12 million of long-term debt in the first nine months of 2009. In addition, the Company repurchased $98 million of trust preferred securities related to its Junior Subordinated Notes for a cash payment of $67 million in the first nine months of 2009. The repurchase of the trust preferred securities was accounted for as an extinguishment of a portion of the Junior Subordinated Notes and resulted in a gain of $31 million.
The Companys cash position (reported as cash and cash equivalents on its condensed consolidated balance sheet) and cash flows are affected by changes in brokerage client cash balances and the associated amounts required to be segregated under regulatory guidelines. Timing differences between cash and investments actually segregated on a given date and the amount required to be segregated for that date may arise in the ordinary course of business and are addressed by the Company in accordance with applicable regulations. Other factors which affect the Companys cash position and cash flows include investment activity in securities, levels of capital expenditures, acquisition and divestiture activity, banking client deposit activity, brokerage and banking client loan activity, financing activity in long-term debt, payments of dividends, and repurchases of CSCs common stock. The combination of these factors can cause significant fluctuations in the levels of cash and cash equivalents during specific time periods.
Capital Expenditures
The Companys capital expenditures were $107 million and $128 million in the first nine months of 2009 and 2008, respectively. Capital expenditures in the first nine months of 2009 were primarily for leasehold improvements, software and equipment relating to the Companys information technology systems, and building improvements. Capital expenditures in the first nine months of 2008 were for software and equipment relating to the Companys information technology systems, a building, and leasehold improvements. Capital expenditures include capitalized costs for developing internal-use software of $12 million in the first nine months of 2009 and $34 million in the first nine months of 2008.
Dividends
CSC paid common stock cash dividends of $209 million and $185 million in the first nine months of 2009 and 2008, respectively.
Share Repurchases
There were no repurchases of CSCs common stock in the first nine months of 2009. CSC repurchased 17 million shares of its common stock for $350 million in the first nine months of 2008. As of September 30, 2009, CSC had remaining authority from the Board of Directors to repurchase up to $596 million of its common stock.
Off-Balance-Sheet Arrangements
The Company enters into various off-balance-sheet arrangements in the ordinary course of business, primarily to meet the needs of its clients. These arrangements include firm commitments to extend credit. Additionally, the Company enters into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For discussion on the Companys off-balance-sheet arrangements, see Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources in the Companys Annual Report on Form 10-K for the year ended December 31, 2008, and note 6 Commitments and Contingent Liabilities in the Notes to Condensed Consolidated Financial Statements.
RISK MANAGEMENT
The Companys business activities expose it to a variety of risks, including technology and operations risk, credit, market and liquidity risk, and legal and reputational risk. Identification and management of these risks are essential to the success and financial soundness of the Company.
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THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
Senior management takes an active role in the Companys risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling various risks. Oversight of risk management has been delegated to the Global Risk Committee, which is comprised of senior managers of major business and control functions. The Global Risk Committee is responsible for reviewing and monitoring the Companys risk exposures and leading the continued development of the Companys risk management policies and practices.
Functional risk sub-committees focusing on specific areas of risk report into the Global Risk Committee. These sub-committees include the:
| Corporate Asset-Liability Management and Pricing Committee, which focuses on the Companys liquidity, capital resources, interest rate risk, and investments; |
| Credit and Market Risk Oversight Committee, which focuses on the credit exposures resulting from client activity (e.g., margin lending activities and loans to banking clients), the investing activities of certain of the Companys proprietary funds, corporate credit activities (e.g., counterparty and corporate investing activities), and market risk resulting from the Company taking positions in certain securities to facilitate client trading activity; |
| Information Security and Privacy Steering Committee, which oversees information security and privacy programs and policies; |
| Investment Advisory and ERISA Committee, which oversees activities in which the Company and its principals operate in an investment advisory capacity or as an ERISA fiduciary; and |
| Investment Products Review Board, which provides senior level oversight of products and services made available to clients. |
The Global Risk Committee reports regularly to the Audit Committee of the Board of Directors (Audit Committee), which reviews major risk exposures and the steps management has taken to monitor and control such exposures.
The Companys Disclosure Committee is responsible for monitoring and evaluating the effectiveness of the Companys (a) disclosure controls and procedures and (b) internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002.
Additionally, the Companys compliance, finance, internal audit, legal, and risk and credit management departments assist management and the various risk committees in evaluating, testing, and monitoring the Companys risk management.
Risk is inherent in the Companys business. Consequently, despite the Companys efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that the Company will not suffer unexpected losses due to operating or other risks.
For a discussion on risks that the Company faces, see Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations Risk Management in the Companys Annual Report on Form 10-K for the year ended December 31, 2008. For updated information on the Companys credit risk and concentration risk exposures, see below. See Item 3 Quantitative and Qualitative Disclosures About Market Risk for additional information relating to market risk.
Credit Risk Exposures
The Company has exposure to credit risk associated with the Companys loans to banking clients. The Companys loan portfolios primarily include first lien 3-, 5- and 7- year adjustable rate residential mortgage loans (First Mortgage portfolio) of $3.5 billion and home equity lines of credit (HELOC portfolio) of $3.2 billion at September 30, 2009.
The Companys First Mortgage portfolio underwriting requirements are generally consistent with the underwriting requirements in the secondary market for loan portfolios. The Companys guidelines include maximum loan-to-value (LTV) ratios, cash out limits, and minimum Fair Isaac & Company (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the
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THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan is conforming or jumbo). These credit underwriting standards have limited the exposure to the types of loans that experienced high foreclosures and loss rates elsewhere in the industry during 2008 and the first nine months of 2009. There have been no significant changes to the LTV ratio or FICO credit score guidelines related to the Companys First Mortgage or HELOC portfolios during the first nine months of 2009. At September 30, 2009, the weighted-average originated LTV ratios were 62% and 59% for the First Mortgage and HELOC portfolios, respectively, and the weighted-average originated FICO credit scores were 759 and 767 for the First Mortgage and HELOC portfolios, respectively.
The Company does not offer loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO credit score of less than 620 at origination), unless the borrower has compensating credit factors. At September 30, 2009, approximately 2% of both the First Mortgage and HELOC portfolios consisted of loans to borrowers with FICO credit scores of less than 620.
The following table presents certain of the Companys loan quality metrics as a percentage of total outstanding loans:
September 30, 2009 |
December 31, 2008 |
|||||
Loan delinquencies (1) |
0.78 | % | 0.54 | % | ||
Nonaccrual loans |
0.37 | % | 0.13 | % | ||
Allowance for credit losses |
0.63 | % | 0.33 | % |
(1) | Loan delinquencies are defined as loans that are 30 days or more past due. |
The Company has exposure to credit risk associated with its securities available for sale and securities held to maturity portfolios which totaled $21.3 billion and $3.0 billion, respectively, at September 30, 2009. These portfolios include U.S. agency residential mortgage-backed securities, U.S. agency notes, corporate debt securities, non-agency residential mortgage-backed securities, certificates of deposit, and asset-backed securities. U.S. agency residential mortgage-backed securities do not have explicit credit ratings, however management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. agencies. Included in non-agency residential mortgage-backed securities are securities collateralized by loans that are considered to be Prime (defined by the Company as loans to borrowers with a FICO credit score of 620 or higher at origination), and Alt-A (defined by the Company as Prime loans with reduced documentation at origination).
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THE CHARLES SCHWAB CORPORATION
Managements Discussion and Analysis of Financial Condition and Results of Operations
(Tabular Amounts in Millions, Except Ratios, or as Noted)
The table below presents the credit ratings for U.S. agency and non-agency residential mortgage-backed securities available for sale and securities held to maturity, including Prime and Alt-A mortgage-backed securities, by year of origination. In some instances securities have divergent ratings from Moodys, Fitch Ratings, or Standard and Poors. In these instances, the Company has used the lowest rating as of September 30, 2009, for purposes of presenting the table below. Residential mortgage-backed securities, particularly Alt-A securities, experienced deteriorating credit characteristics, including increased delinquencies and valuation pressure, in the first nine months of 2009. For a discussion of the impact of current market conditions on residential mortgage-backed securities, see Current Market Environment.
AAA | AA to A | BBB | BB or Lower | Total | ||||||||||||||||||||||||||||||||||||
Amortized Cost |
Net Unrealized Gain (Loss) |
Amortized Cost |
Net Unrealized Loss |
Amortized Cost |
Net Unrealized Loss |
Amortized Cost |
Net Unrealized Loss |
Amortized Cost |
Net Unrealized Gain (Loss) |
|||||||||||||||||||||||||||||||
U.S. agency residential mortgage-backed securities: |
||||||||||||||||||||||||||||||||||||||||
2005 |
$ | 630 | $ | 4 | $ | | $ | | $ | | $ | | $ | | $ | | $ | 630 | $ | 4 | ||||||||||||||||||||
2006 |
415 | (1 | ) | | | | | | | 415 | (1 | ) | ||||||||||||||||||||||||||||
2007 |
791 | 28 | | | | | | | 791 | 28 | ||||||||||||||||||||||||||||||
2008 |
4,633 | 109 | | | | | | | 4,633 | 109 | ||||||||||||||||||||||||||||||
2009 |
5,247 | 43 | | | | | | | 5,247 | 43 | ||||||||||||||||||||||||||||||
Total |
11,716 | 183 | | | | | | | 11,716 | 183 | ||||||||||||||||||||||||||||||
Non-agency residential mortgage-backed securities: |
||||||||||||||||||||||||||||||||||||||||
2003 |
87 | (7 | ) | 8 | (1 | ) | | | | | 95 | (8 | ) | |||||||||||||||||||||||||||
2004 |
156 | (13 | ) | 80 | (14 | ) | 10 | (4 | ) | | | 246 | (31 | ) | ||||||||||||||||||||||||||
2005 |
37 | (2 | ) | 176 | (43 | ) | 252 | (54 | ) | 385 | (96 | ) | 850 | (195 | ) | |||||||||||||||||||||||||
2006 |
14 | | 40 | (4 | ) | | | 693 | (241 | ) | 747 | (245 | ) | |||||||||||||||||||||||||||
2007 |
104 | (6 | ) |